Now we will focus on how to tap the cash value of the permanent life insurance policy.
Cash value is the signature feature of a permanent life insurance policy, because unlike a Term life policy, which only has Face Value (the amount that will be paid to the beneficiary if the insured dies), a Permanent Life Insurance policy also has the Cash Value.
Cash value sits in a savings account that is funded by a portion of the premium. With Whole Life and Universal Life, the insurance company usually promises a minimum level of interest (after deducting cost of insurance and other expenses), you will earn more if the investment performs well. With Variable Universal Life, the investments have no guarantees. With any kind of policy, if you surrender it, you will receive the balance in the cash value account, minus any outstanding loans.
If you have a sizable cash value amount in a policy, and need cash, you have 4 options:
a. Stop paying premiums
You won't get money from the policy, but at least you will save money which will otherwise go toward premium payments. The funds in your cash value account will pay the premium. If your cash value size is big enough and the investment performs well, the return could be more than the various costs, in that case your cash value could still grow.
b. Take partial withdrawals
If you need cash but don't want to surrender your policy, you can withdraw your basis - the amount you paid in premiums - tax free!
Withdrawals that exceed the cost basis will result in tax at your ordinary income level. Note the death benefit will be lowered by the amount of withdrawals.
c. Take policy loans
You can borrow against your policy. This is a good option if you need occasional cash, and unlike any other loans you want to take, you are not subject to any credit check to take this loan, because you are using your cash value as a collateral.
Collateral means while you are taking a loan, your assets used as a collateral is still earning the return as usual, and here is an even better news - the loan's interest rate is usually lower than the rate the cash value earns (this is usually true for Whole Life, but not for other permanent life policies).
You can pay the interest out of policy, if not, your loan balance will grow. You can also earn interest with the accumulated dividends or interest build ups in your savings account.
d. Cash the entire policy
If your loan balance exceeds your cash value, your policy could lapse, but insurers will give you plenty of warnings to catch up before it happens. If your policy does lapse, you will owe tax on the amount of the cash value, including loans that exceed the premiums you paid in. This could be a problem if you have spent the loan long time ago.
If you don't repay the loan, or only pays back partial amount of the loan, the balance will be deducted from your death benefit when you die.
The Bottom Line
It's important to note that for all the above options, you are depriving your family of a tax-free inheritance for whatever amount of loans or withdrawals you are taking. You should only borrow if you intend to pay back.
In our next blog post, we will discuss the various options one could consider to exchange a permanent life policy.