Life insurance policies can provide more than just a death benefit. If you buy the right type of policy, your money does more than just pay for coverage. Understanding what happens inside a life insurance policy and how your premium payments are handled can help you learn to leverage the power of tax-deferred accumulation and tax-free loans.
Permanent Life Insurance
Permanent life insurance is the kind that's designed to last forever. Well, to be more precise, "forever" to most life insurance companies usually means 100 years old. If you've bought this type of policy, your coverage should last for the rest of your life and your premium payment should remain level the entire time. Permanent policies cost more than term insurance products, the ones that expire after 10, 20 or 30 years, but a major advantage is that you'll never have to worry about being without coverage or struggle to find a new policy when you're older and possibly less healthy.
Cash Value Accumulation
The accumulation of equity inside a permanent life insurance policy has the potential to be largely advantageous, or detrimental, to your coverage. To keep your premium payments level for the rest of your life, insurance companies charge you an amount greater than what's necessary in the beginning. The portion of your payment that exceeds the cost of the insurance gets set aside in a separate account, referred to as "cash value." As you get older and approach the end of your natural life, the cost of providing life insurance coverage increases, eventually exceeding your premium payment. After that point, the insurance company uses your accumulated cash value to supplement your inadequate payment. Simply put, by paying more than necessary in the beginning, you can pay less than necessary later.
Life insurance surrender value refers to how much money you'd get if you canceled a permanent policy. Before you're even covered, insurance companies often spend quite a bit of money paying underwriters, commissions, fees for medical records and DMV reports, lab testing and physical exams. Surrender charges help recoup some of those expenses if you cancel your policy too soon. Many policy contracts have surrender charges that last for more than 10 years. If you terminate your coverage, the insurance company will keep most, if not all, of the cash value, unless you've had the policy long enough to surpass the surrender period.
Accessing Your Money
Getting your hands on some of the cash value from your life insurance policy is a relatively easy process. You can withdraw much of the accumulated cash in the form of a loan by simply filling out the right forms. If you're balking at the idea of borrowing your own money, remember that the IRS requires taxes be paid on investment gains, and an ordinary withdrawal of cash value might include interest earnings. However, by structuring your withdrawal as a loan, you avoid tax liability. Plus, the interest charged to your loan goes directly to your cash value, helping you rebuild the account faster. One thing to keep in mind when considering this type of loan is that whatever amount remains outstanding when you die gets subtracted from the death benefit payable to your heirs.
Gregory Gambone is senior vice president of a small New Jersey insurance brokerage. His expertise is insurance and employee benefits. He has been writing since 1997. Gambone released his first book, "Financial Planning Basics," in 2007 and continues to work on his next industry publication. He earned a Bachelor of Science in psychology from Fairleigh Dickinson University.