Cash-value life insurance — such as whole-life and universal life policies — is often criticized because it’s hard to follow where all your premiums go and how your value builds. But as you get older, you may find that this complexity translates into more ways to pull money out and still preserve your life-insurance coverage.
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Basically, a whole-life policy involves trading higher out-of-pocket costs for some guarantees. You pay a fixed annual premium that depends on your age, health and the size of the policy, and in return you know what your minimum cash value and death benefit are worth every year. If the insurance company invests well (usually in bonds and mortgage securities) and controls other expenses, you’ll receive policy dividends, which can further build up your cash value and death benefits. If yours is a mutual insurance company, you’re legally considered an owner of the company and share in its gains.
There are two ways to extract cash from a permanent life policy: a withdrawal or a policy loan. If you simply cash in the policy, which is known as surrender, you take back the cash value all at once, minus any outstanding loans. But that means you give up the death benefit and owe income tax on the policy’s gains over and above the premiums you’ve paid. If you bought the policy at, say, age 25 and you’re now 60, that’s an enormous tax hit. It would be smarter to withdraw up to the amount you’ve paid in premiums, your basis, which you may do without paying tax.
If you need occasional cash, the best way to claim it is a policy loan. You reduce your death benefit by the amount of the loan plus interest (which is generally low, perhaps 6 percent), but you never have to pay it back. If the policy is still in force when you die, your heirs get the remaining reduced death benefit tax-free.
The downside of a policy loan is that you need to be very careful not to let your policy lapse, or else you’ll owe taxes on the loan, even though you’ve spent the money and may think you borrowed the cash from your own savings. Although you can have the interest deducted from the remaining cash value, that’s dangerous. It’s wise to pay at least the annual interest as it accumulates.
Another option is to make a tax-free conversion into an income annuity. You’ll give up the death benefit and owe taxes on a portion of each annuity payout. But in exchange for paying taxes, you stop paying premiums and can be assured of a steady stream of income for life or for a specified number of years.
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