Did you know that you can use your life insurance policy as an investment tool? According to a study by LIMRA, the average rate of return on a whole life insurance policy over 20 years was 5.5%, which is higher than the average return on a 10-year Treasury bond (4.5%) or a 20-year corporate bond (5.1%). This means that you can potentially grow your money faster and safer with life insurance than with other investments.
But how does life insurance work as an investment? And what are the benefits and drawbacks of this strategy? In this article, we will explain how you can use life insurance as an investment tool, and how to make it work for you. We will focus on the USA context, but we will also provide some general information for readers from other countries.
Understanding Life Insurance as an Investment
Life insurance is a financial product that pays a sum of money to your beneficiaries when you die. But some types of life insurance can also serve as an investment tool, allowing you to build cash value and access it for various purposes while you are alive.
There are two main types of life insurance: term and permanent. Term life insurance provides coverage for a specific period of time, such as 10, 20, or 30 years. If you die within the term, your beneficiaries will receive the death benefit. If you outlive the term, the policy will expire and you will get nothing. Term life insurance is usually cheaper than permanent life insurance, but it does not have any cash value.
Permanent life insurance provides coverage for your entire life, as long as you pay the premiums. It also has a cash value component, which is a savings account that grows over time. A portion of your premium goes toward the cash value, and the rest goes toward the cost of insurance. The cash value accumulates tax-deferred, meaning you do not pay taxes on the growth until you withdraw or borrow from it. You can access the cash value for various reasons, such as:
- Paying for your retirement expenses, such as living costs, health care, travel, etc.
- Funding your children’s or grandchildren’s education, such as tuition, books, fees, etc.
- Supplementing your income, such as starting a business, pursuing a hobby, etc.
- Paying off your debts, such as mortgage, car loans, credit cards, etc.
- Covering your emergency expenses, such as medical bills, home repairs, etc.
- Donating to a charity, a cause, or an organization that you care about.
There are different types of permanent life insurance, such as whole life, universal life, variable life, and variable universal life. Each type has its own features, benefits, and drawbacks, and may suit different goals and needs. Here are some of the main differences among them:
| Type of Permanent Life Insurance | Features | Benefits | Drawbacks |
|---|---|---|---|
| Whole life | Provides a fixed death benefit and a guaranteed cash value growth rate. The premium and the cash value are determined by the insurer and are not flexible. | Offers a predictable and stable return on your investment. Provides a lifelong coverage and protection. | Has a higher cost than term life insurance. Has a lower return than other investments. Has limited flexibility and control over your policy. |
| Universal life | Provides a flexible death benefit and a variable cash value growth rate. The premium and the cash value are adjustable by the policyholder and depend on the current interest rate. | Offers a flexible and customizable policy that can adapt to your changing needs and preferences. Allows you to adjust your premium and cash value according to the market conditions. | Has a higher cost than term life insurance. Has a lower return than other investments. Has a higher risk of losing your coverage if the interest rate falls or you miss a payment. |
| Variable life | Provides a fixed death benefit and a variable cash value growth rate. The premium and the cash value are determined by the insurer and are not flexible. The cash value is invested in subaccounts, which are similar to mutual funds, and can increase or decrease in value depending on the performance of the subaccounts. | Offers a potentially higher return on your investment. Allows you to choose from a variety of subaccounts that suit your risk tolerance and investment objectives. | Has a higher cost than term life insurance. Has a higher risk of losing your cash value if the subaccounts perform poorly. Has limited flexibility and control over your policy. |
| Variable universal life | Provides a flexible death benefit and a variable cash value growth rate. The premium and the cash value are adjustable by the policyholder and depend on the performance of the subaccounts. The cash value is invested in subaccounts, which are similar to mutual funds, and can increase or decrease in value depending on the performance of the subaccounts. | Offers a flexible and customizable policy that can adapt to your changing needs and preferences. Offers a potentially higher return on your investment. Allows you to choose from a variety of subaccounts that suit your risk tolerance and investment objectives. | Has a higher cost than term life insurance. Has a higher risk of losing your cash value and your coverage if the subaccounts perform poorly or you miss a payment. Has a higher complexity and management requirement. |
The following image shows the difference between term life and permanent life insurance in terms of coverage, cash value, and cost.
Pros and Cons
Using life insurance as an investment can have some advantages and disadvantages, depending on your situation and goals. Here are some of the pros and cons of this strategy:
Pros
- Provides a tax-advantaged way to save and invest your money. You do not pay taxes on the cash value growth until you withdraw or borrow from it. You can also access the cash value without paying taxes or penalties, unlike some other retirement accounts. The death benefit is usually tax-free for your beneficiaries, unless it exceeds the estate tax exemption limit.
- Provides a financial protection and a legacy for your loved ones. You can ensure that your beneficiaries will receive a lump-sum payment when you die, regardless of the market conditions or your health status. You can also use the death benefit to pay for your final expenses, such as funeral costs, taxes, debts, etc. You can also use the death benefit to leave a lasting impact on your family, your community, or your cause. You can also create or supplement an inheritance for your heirs, such as your children, grandchildren, or other relatives.
- Provides a diversification and a balance for your portfolio. You can use life insurance to complement your other investments, such as stocks, bonds, real estate, etc. You can use the cash value to provide a stable and guaranteed return, while using the subaccounts to provide a higher and variable return. You can also use the cash value to hedge against inflation, market volatility, or interest rate fluctuations.
Cons
- Has a higher cost and a lower return than other investments. You have to pay for the cost of insurance, the administrative fees, the commissions, and the surrender charges, which can reduce your cash value and your return. You may also get a lower return than other investments, such as stocks, bonds, real estate, etc., especially if you choose a conservative or a guaranteed option.
- Has a higher risk and a lower liquidity than other investments. You may lose your cash value and your coverage if the market performs poorly, the interest rate falls, or you miss a payment. You may also face penalties or taxes if you withdraw or borrow from your cash value before a certain period of time. You may also have a limited access to your cash value, depending on the terms and conditions of your policy.
- Has a higher complexity and a lower transparency than other investments. You may have a hard time understanding and comparing the different types, features, and options of life insurance policies. You may also have a hard time finding and evaluating the performance, the fees, and the risks of the subaccounts. You may also have a hard time managing and updating your policy, depending on the flexibility and the control of your policy.
Making it Work for You (USA)
If you want to use life insurance as an investment tool within the USA context, you need to consider some factors that may affect your strategy and outcome. Here are some of them:
Age: Your age can influence your life insurance needs, costs, and returns. Generally, the younger you are, the cheaper and easier it is to get life insurance, and the longer you have to grow your cash value. However, you may also have less income and more expenses, such as student loans, mortgage, childcare, etc., which can limit your ability to pay the premiums and invest in the cash value. On the other hand, the older you are, the more expensive and difficult it is to get life insurance, and the shorter you have to grow your cash value. However, you may also have more income and less expenses, such as retirement savings, paid-off debts, etc., which can enable you to pay the premiums and invest in the cash value.
Financial Goals: Your financial goals can determine your life insurance needs, objectives, and options. You should consider your short-term and long-term goals, such as saving for retirement, funding your children’s education, paying off your debts, leaving a legacy, etc. You should also consider your risk tolerance, time horizon, and expected return. Based on your goals, you can choose the type and amount of life insurance that suits you best, and the strategy to use the cash value to achieve your goals.
Tax Advantages: One of the main benefits of using life insurance as an investment is the tax advantages that it offers. In the USA, the cash value grows tax-deferred, meaning you do not pay taxes on the growth until you withdraw or borrow from it. You can also access the cash value without paying taxes or penalties, unlike some other retirement accounts. The death benefit is usually tax-free for your beneficiaries, unless it exceeds the estate tax exemption limit, which is $11.7 million per person in 2021. However, you should also be aware of some tax rules and implications that may affect your life insurance policy and investment, such as:
- Modified Endowment Contract (MEC): A MEC is a life insurance policy that fails the 7-pay test, which means that the amount of money paid into the policy in the first seven years exceeds the amount allowed by the IRS. A MEC loses some of the tax benefits of a life insurance policy, such as the tax-free access to the cash value. If you withdraw or borrow from a MEC, you will have to pay income tax and a 10% penalty on the earnings, unless you are over 59.5 years old or disabled. To avoid creating a MEC, you should limit the amount of money you pay into your policy in the first seven years, or use a 1035 exchange, which is a tax-free transfer of funds from one life insurance policy to another.
- Transfer for Value Rule: The transfer for value rule is a tax rule that applies when you transfer your life insurance policy to someone else for valuable consideration, such as money, property, or services. If you do so, the death benefit will lose its tax-free status and will be subject to income tax, unless the transfer falls under one of the exceptions, such as a transfer to the insured, a partner, a corporation, or a trust. To avoid triggering the transfer for value rule, you should be careful when you transfer your policy to someone else, and consult a tax professional if you are not sure about the tax consequences.
- Generation-Skipping Transfer Tax (GSTT): The GSTT is a tax that applies when you transfer money or property to someone who is two or more generations younger than you, such as your grandchildren or great-grandchildren. The GSTT is in addition to the estate tax and the gift tax, and has the same exemption limit of $11.7 million per person in 2021. If you use your life insurance policy to create or supplement an inheritance for your grandchildren or great-grandchildren, you may have to pay the GSTT, unless you use a trust or a dynasty trust, which are legal entities that can hold and distribute assets for multiple generations without triggering the GSTT. To avoid paying the GSTT, you should plan ahead and use the appropriate tools and strategies to transfer your assets to your heirs.
These are some of the factors that you should consider when using life insurance as an investment tool within the USA context. However, these factors may not apply or may differ for readers from other countries, as they may have different regulations and product options. Therefore, you should also do your own research and consult a professional advisor before making any decisions.
Conclusion
Life insurance can be used as an investment tool, allowing you to build cash value and access it for various purposes while you are alive. However, life insurance is not a typical or a suitable investment for everyone. You should consider the benefits and drawbacks of this strategy, and compare it with other investments, such as stocks, bonds, real estate, etc. You should also follow some tips and best practices to make life insurance work for you as an investment, such as choosing the right type and amount of life insurance, shopping around and comparing different policies and companies, reviewing and updating your policy regularly, and seeking professional advice if you need it.
If you are interested in using life insurance as an investment tool, you should start by assessing your goals and needs, and finding out how much coverage and cash value you need. You should also research and compare different types of life insurance policies and companies, and choose the one that suits your situation and preferences. You should also review and update your policy regularly, and make any necessary changes to your coverage, cash value, beneficiaries, or subaccounts. You should also consult a licensed and independent financial advisor, such as this one, if you need help or guidance with choosing, buying, or managing your life insurance policy.
We hope this article has helped you understand how to use life insurance as an investment tool. If you have any feedback or questions, please feel free to leave a comment below or contact us anytime. Thank you for reading and happy planning!
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