How to use life insurance to supplement savings
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You're probably familiar with life insurance and its primary role – to protect your dependents if you pass away and can no longer provide them financial support. A life insurance policy – whether permanent life insurance or term life insurance – will pay your beneficiaries an income tax-free death benefit which can help ensure that their expenses will be covered and their needs met in the absence of your salary, pension, or social security.1
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But life insurance can play another vital role. Permanent life policies allow policyholders to manage their cash value, death benefits, and expenses. Many policyholders use life insurance as a tax-efficient way to help supplement their other savings plans, investments, and retirement accounts. By taking advantage of a policy's cash value component, life insurance can be a useful financial tool not only in the event of the policyholder's death but also during the policyholder's life.2 Because it offers a death benefit and a tax-efficient cash value component, many people consider a cash value life insurance policy to be one of their most valuable financial assets. This article can help you decide if it's right for you by explaining the following:
How a life insurance policy helps you build savings
Which types of life insurance policies offer cash value components
Which type of life insurance policy with cash value might be right for you
How to get started
How does a life insurance policy help you build savings and wealth?
There are two basic types of life insurance – permanent life insurance and term life insurance. It’s important to note that term life insurance is not an appropriate choice for those that wish to have life insurance with cash value. Why? Because while a term life insurance policy offers a death benefit like permanent life insurance, coverage is temporary and doesn't allow the policyholder to build cash value.
Permanent life insurance policies come in two forms – whole life insurance and universal life insurance.3 Both are also known as cash value policies because they not only pay a death benefit but also have a built-in component that lets you build cash value over time. These funds are available for any purpose while you are still alive, from paying college tuition to buying a new car or even helping to fund your retirement .4 Many permanent life insurance policyholders use their cash value to pay their life insurance premiums in the later years of their policy. Here's how it works: When you pay your policy premium, a portion goes towards the cost of insuring you, a portion goes to the insurance company's fees, and a portion goes to the policy’s cash value.
Depending on which type of whole life or universal life insurance policy you choose, your cash value will grow either by earning guaranteed interest or by accruing gains from subaccounts or other investment vehicles. It is important to note that interest and gains accrue on a tax-deferred basis — meaning you won’t have to pay taxes on gains until you withdraw the funds — a key advantage that life insurance has over many other financial vehicles. Then, after you have built up cash value, there will come a point when you are allowed to access the cash. You can do this in three ways:
Withdrawal: You can simply withdraw some of the cash value. But be aware: This will reduce the death benefit in most cases. So if your goal is to maximize that benefit for future protection, you might want to avoid straight withdrawals unless it is an emergency.
Loan: You can take out a loan against the cash value of your policy. Then, you have a choice. You can pay back the loan - with interest - which will preserve the death benefit at its original amount. Or you can choose not to pay back the loan or the interest – in which case the death benefit will be reduced by the loan amount. Either way, a loan has an advantage over a withdrawal: The funds for the loan come from the insurance company - not from your policy's cash value - so whatever cash value you have built up continues to earn interest or investment gains even while the loan is outstanding.
Surrender: You can receive the entire cash value of your life insurance policy (minus any applicable surrender charge) by terminating – or “surrendering” – your policy. When you choose this option, your life insurance coverage will end, as will your premium payments. Please remember to ask your life insurance company about possible tax consequences before moving forward.
As mentioned above, you can also use the accrued cash value to pay your life insurance premiums in the later years of your coverage. Many policyholders who don't need the funds for other purposes choose this option.
Which cash value life insurance policy is right for you?
When you choose to get a life insurance policy for savings, you'll then have to decide which of the various policy types is best for your needs. This decision should be based on the type of coverage offered, the cost of the premiums, and – importantly – how the cash value portion works. Each policy type works somewhat differently, with the most significant difference being the specific cash value and investment options offered.
Whole Life Insurance
With whole life insurance, your cash value accrues at a fixed interest rate. In addition, whole life insurance offers fixed monthly premiums, a guaranteed death benefit, and – in some cases – dividends from the insurance company . 5 With its guaranteed premium, interest rate, and death benefit, it is a simple and stable choice but often more expensive than other policy types.
Universal Life Insurance
With these policies, cash value is guaranteed to grow at a specified minimum interest rate, and while these insurance policies don’t earn dividends, account value can grow faster than the guaranteed rate depending on the insurance company’s investing performance. But there’s a key difference compared to whole life : the premiums are variable. You have the flexibility to raise or lower your premium payments as you see fit, within the limits of the policy. 6 This gives added flexibility to people with variable incomes. There are also variations on universal life that provide more growth potential along with a degree of investment risk:
Indexed universal life:7 Your cash value is tied to the performance of an index such as the S&P 500, with caps for minimum and maximum rates of return which limit your investment risk and growth potential.
Variable Universal Life Insurance:8 You allocate your cash value into grouped stock market and bond investments called "subaccounts." With this type of policy, you assume all the investment risk but can also benefit from upside growth.
If you are concerned about your dependents’ financial protection in the event of your death, and you can afford to invest in a cash value life insurance policy, it may be worth considering. Consider: a cash value life insurance policy offers guaranteed financial protection in the event of your death and a tax-efficient way to build your net worth while you are alive. Other financial vehicles may not provide both. While they may or may not produce higher returns than a life insurance policy, they may not deliver an income tax-free lump sum payment if you pass away. And unless they’re in a retirement account, those investments may not offer the generous tax advantages of a life insurance policy. So no matter what other financial assets you already hold, it may be worth adding permanent life insurance to your portfolio.
How to get started
It’s important to remember that life insurance should complement, not replace, traditional retirement savings. If you think that a life insurance policy may be right for you, we suggest talking to a knowledgeable professional who can answer detailed questions about the different types of policies discussed above and help you to make a fully-informed decision. If you don't have someone to discuss insurance with, Guardian can help you find a nearby financial professional who will take the time to learn about your situation and present you with options that will incorporate life insurance into your retirement planning, ensuring a well-rounded and secure financial future.