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Life insurance primarily pays a sum to beneficiaries upon death. However, it serves other purposes, too. According to a recent NerdWallet study, 23% of Americans purchase life insurance to build cash value and save for retirement.
Although life insurance can accumulate cash value, it may not be the optimal investment for everyone. Understand how cash value functions and determine if it aligns with your financial goals.
Consider this Nerdy Tip: Before exploring investment options, assess if you require life insurance to replace lost income for your beneficiaries upon your death.
How does life insurance work as an investment?
Life insurance can function as an investment in two main ways: term and permanent. While both provide death benefits, only permanent life insurance offers the potential to accumulate cash value.
Permanent policies, like whole life insurance, allocate a portion of your premium to a cash value reserve. This money grows tax-deferred over time. You can access it through withdrawals or loans to cover expenses during your lifetime.
On the other hand, term life insurance policies do not build cash value. They offer coverage for a specified period, typically 20 or 30 years, and are more affordable than permanent options. Some advisors suggest “buy term and invest the rest,” directing you to purchase term life insurance and invest the savings from not buying a more expensive permanent policy into other assets like stocks. Consider consulting a fee-only financial advisor to determine if this strategy aligns with your financial goals.
Why should life insurance not be used as an investment?
Using life insurance as an investment may not be optimal for several reasons. Here are three key considerations to bear in mind:
Firstly, more suitable investment options are likely available if you don’t require insurance coverage. Life insurance is primarily designed to provide a financial cushion for beneficiaries after their death. If insurance coverage isn’t necessary, exploring alternative investments may better align with your financial goals.
Secondly, the cash value of a life insurance policy does not typically transfer to your heirs along with the death benefit. It serves as a fund that you can access during your lifetime through withdrawals or loans. However, any withdrawals or loans may reduce the death benefit or accumulate interest, impacting your beneficiaries’ overall benefit.
Lastly, obtaining life insurance can be influenced by your age and health, potentially requiring a medical examination for eligibility. This contrasts with other investment vehicles like 401(k)s or IRAs, which do not typically require such assessments.
These factors can help determine whether life insurance aligns with your investment needs and financial objectives.
Using life insurance to save for retirement
Using life insurance as a savings vehicle for retirement can be advantageous if you purchase a permanent policy at a young age. Over time, the policy’s cash value has the potential to grow significantly. While accessing this cash may decrease the death benefit, it can provide flexibility if you no longer require insurance coverage and prefer to use the accumulated funds for various expenses.
Nerdy Tip: Relying solely on a life insurance cash value may not suffice for a fully supported retirement. Consult with a fee-only financial advisor to devise a retirement plan that suits your needs best.
Flexible cash withdrawals
The cash value in a life insurance policy offers flexibility, allowing you to withdraw funds at any time for any purpose. This differs from retirement vehicles such as traditional IRAs or 401(k)s, which mandate minimum distributions starting in your early 70s and may incur tax penalties for early withdrawals. Life insurance cash value does not impose similar withdrawal restrictions, providing greater flexibility in accessing your funds.
Tax-free withdrawals
Withdrawals from a life insurance policy up to the policy basis (the amount you’ve paid into the policy) are typically tax-free. However, any withdrawals exceeding the policy basis may be subject to income tax on the gains.
Tax-free cash-value loans
You can use tax-free cash value loans from your life insurance policy to withdraw more than the policy basis without triggering income tax on the gains. These loans do not count as taxable income but accrue interest, which compounds over time. The policy may lapse if the loan amount exceeds the total cash value. To manage this, it’s advisable to at least cover the annual interest to prevent the loan from growing uncontrollably.
While you’re not obligated to repay the loan during your lifetime, any outstanding balance at the time of your death is typically subtracted from the death benefit. This reduces the payout to your life insurance beneficiaries.
Did you know… You can borrow against your cash value without needing to qualify for a loan? The cash is available for you to access whenever you need it.
Get the most out of your cash value growth
Some insurers offer flexibility in how quickly your cash value grows. For instance, you can pay all premiums for a whole life policy within the first 10 years or even as a single lump sum, accelerating cash value growth. However, opting for shorter premium payment periods typically results in higher individual premiums than spreading them out.
Important: Be cautious about overfunding your life insurance policy, as it could trigger IRS classification as a modified endowment contract. Withdrawing cash value early may lead to additional taxes and fees.
If you select a mutual insurance company owned by policyholders, you might also accumulate cash value through dividends. These companies often distribute annual dividends to whole-life policyholders, who can purchase paid-up additions (PUAs). PUAs act as small increments of permanent life insurance funded by dividends, enhancing the overall value of your investments.
Types of life insurance policies you can use as an investment
Cash value growth in your life insurance policy depends on several factors, including the type of policy, duration of coverage, premiums paid, and specific policy terms.
Whole life insurance:
- Features fixed premiums, a guaranteed death benefit, and predictable cash value growth.
- Cash value grows at a fixed rate determined by the insurer, unaffected by market fluctuations in interest rates or dividends.
Universal life insurance:
- Offers flexibility to adjust premiums and death benefits within certain limits to accommodate changing needs.
- Cash value typically earns interest based on the insurer’s declared rate, which can vary, posing more risk than whole life. Some policies include a minimum interest rate safeguard, like 2%, to protect against significant losses.
Variable universal life insurance:
- Provides flexibility in adjusting premiums, death benefits, and investment choices among subaccounts.
- Cash value growth depends on the performance of selected subaccounts, such as those investing in stocks and bonds. The insurer may also offer a fixed interest rate option based on the policy terms.
Indexed universal life insurance:
- Combines the flexibility of universal life insurance with cash value growth tied to stock market indexes like the S&P 500.
- Cash value growth is linked to index performance, often with safeguards like interest rate floors (e.g., 0%) and caps on maximum interest rates to manage investment risk.
Variable life insurance:
- Offers diverse investment options for cash value with potential for high returns but carries higher investment risk.
- The cash value earns interest based on the performance of subaccounts chosen by the policyholder, such as indexes and mutual funds. Insurers typically set minimum and maximum interest rates to mitigate potential losses.
Other reasons to buy life insurance
While building investment is a common motivation for obtaining life insurance, there are several other practical reasons people choose to invest in coverage:
- Providing income replacement
- Securing burial insurance to cover final expenses
- Settling debts with life insurance proceeds
- Planning to leave an inheritance
Frequently Asked Questions
Is life insurance a good investment?
Life insurance can help build savings and provide financial security for loved ones. However, its effectiveness as an investment depends on individual financial goals and circumstances.
How does life insurance work as an investment?
Life insurance policies with cash value components allow policyholders to accumulate funds over time, which can be accessed through withdrawals or loans. The cash value growth varies depending on the type of policy chosen and market conditions.
What are the benefits of using life insurance as an investment?
Benefits include potential cash value growth over time, tax advantages on withdrawals up to the amount paid in premiums (basis), and flexibility in accessing funds without immediate tax consequences.
What are the risks of using life insurance as an investment?
Risks include policy fees, potential policy lapses if loan repayments aren’t made, and fluctuations in cash value growth tied to market conditions or policy performance.
Should I buy life insurance primarily as an investment?
It’s crucial to evaluate life insurance primarily for its intended purpose of providing financial protection for dependents. While it can complement an investment strategy, ensure it aligns with your overall financial goals.
How do I know if life insurance as an investment is right for me?
Consult with a financial advisor to assess your specific financial situation, goals, and risk tolerance. They can help determine if life insurance as an investment aligns with your long-term financial plans.
Conclusion
While life insurance can be used as an investment tool to accumulate savings and provide financial security, it’s essential to carefully evaluate its suitability based on individual financial goals and circumstances. Understanding the potential benefits and risks, consulting with a financial advisor, and aligning the decision with broader financial planning goals are crucial steps in determining whether life insurance as an investment is appropriate for your needs.