YOU ASK:

What are the pros and cons of life insurance with cash value?

WE ANSWER:

This type of insurance provides two major benefits: a death benefit, which is paid out upon the death of the insured, and, a cash value, which is accumulated during the lifetime of the policyholder.

The cash value can be used as an investment with certain tax benefits. It can also be used as a fund source against which borrowings can be made, and, also as a source for premium payments. It can also be passed on the policyholder's heirs.

The types of cash-value insurance include whole life, universal and variable life.

Characteristics of cash-value life insurance policies

  • These policies provide protection up to the ages of 95 to 100.
  • Premium payments are fixed and remain level throughout the policy period. Premiums have to be paid in a timely manner otherwise the policy will cease to provide protection.
  • Premiums can be relatively expensive especially during the onset of the policy. This is offset during the latter part of the policy when the insured individual's mortality cost is increasing but the premium amount remains the same.
  • Cash value component enjoys certain tax benefits.

What are the pros and cons of life insurance with cash value?

Pros:

  • Coverage is for a lifetime.
  • Choice of fixed or flexible premium payments. In universal, cash-value policies, for example, the policyholder can choose to vary payments on a year-to-year basis.
  • Loans can be secured against the cash value.
  • Policy can be surrendered for the cash value.
  • Cash value can also be converted into an annuity.
  • Tax-deferred status on the cash value.
  • Policy can be augmented with a rider, which gives the right buy additional life insurance without the need for evidence of insurability.
  • Recession-proof long-term benefits.

Cons:

  • Costs much more compared to term insurance.
  • There are better investment options. The rate of return on this type of policy is considered conservative compared to other investment vehicles.
  • Cash value policies tend to have several hidden charges. These fees can eat up much of the accumulated value.
  • Tax benefits are not in the same level as individual retirement accounts or 401(k)s.

How is cash value life insurance taxed?

The proceeds paid out because of the death of the insured are not subject to tax. However, withdrawing money early may be considered as taxable income.

When money is withdrawn against the cash value, the amount can be subject to tax if it is greater than the total premiums paid. For instance, you paid a total of $10,000 in premiums and you surrendered the policy early to get $20,000, the $10,000 difference will be treated as income and therefore subject to tax.

The insurance company will provide you with IRS Form no. 1099-R, which will reflect the total proceeds you get and the taxable portion. You are to report this in line numbers 16a and 16b when filing Form no. 1040.

Meanwhile, money that is loaned against the cash value is not subject to tax when the policy remains in force. What many people do is to withdraw the total amount they paid for premiums and then get a loan on the remaining amount.

In cases where the accumulated cash value exceeds the amount for the death benefit, the policy then becomes a modified endowment contract or MEC which subjects the cash value to a 10 percent tax.

What should I consider when buying cash value whole life insurance?

  • Purchase from a mutual company. When you buy from a mutual company you get to be recognized as a participant in the company's gains which could allow you to earn dividends.
  • Do not easily be swayed by future income projections by agents. These are but hypothetical figures and most of the time companies will present them in very optimistic scenarios.
  • Look for past performance instead to have a gauge on how your investment will turn out. Do careful research on past performance of companies by looking at their yearly rates over a twenty-year period.
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