Life insurance can mitigate the financial impact of losing someone close to you. This type of insurance can help families pay off debts and loans and provide the money they need to cover their daily expenses.
This type of financial benefit, however, is only one of many elements of life insurance. Life insurance is a complex investment with benefits and disadvantages. Depending on how you manage it, you can use it to build your wealth.
How does life insurance operate?
There are many types of life insurance policies, but they fall into two main categories: term and permanent. Each has its pros and cons, and understanding how they work is the key to knowing if it is a wise investment.
Term Life Insurance
This type of policy is for a specific period. The plan pays a death benefit if the insured passes away within a certain period. This means that they can only receive the payment during the time the policy is in effect. The policyholder can choose to renew the policy, convert it into permanent coverage, or cancel the plan once the term has expired.
Permanent life insurance
Unlike term life insurance, a permanent policy is not subject to expiration. There are two main types of permanent life insurance: universal and whole life plans. Both combine a death benefit with an investment component.
Whole-life policies provide coverage throughout the lifetime of the insured, and savings can grow with a guaranteed rate. Universal life insurance uses a different premium structure, and the earnings are based on the performance of the market.
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What are the advantages of a permanent life insurance policy?
A permanent life insurance plan can be used to build wealth. This is one of its main benefits. According to the financial site Investopedia, this type of insurance has many other advantages.
- Tax-deferred Growth
The policyholder can invest in permanent life insurance on a tax-deferred basis. This means that they will not be charged taxes on interest, dividends, or capital gains generated by the cash value of the plan unless and until they withdraw their proceeds.
Investopedia explains: “This is similar in tax terms to certain retirement accounts such as IRAs, 401 (k)s and 403 (b)s.” If you max out your contributions year after year to these accounts, it may be a good idea to invest in permanent life insurance.
- Coverage for life
Permanent policies provide coverage for the entire life of the insured, as opposed to term life insurance, which terminates after a certain number of years.
This benefit is attractive if you expect to have people financially dependent on you for a more extended period than a standard term policy, such as a disabled child.
- Cash value
Unlike tax-advantaged retirement programs such as the 401(k), policyholders are able to borrow from the cash value of their permanent life insurance policies if they need it.
- Benefits Accelerated
Suppose you have a critical illness, such as invasive cancer, a heart attack, kidney failure, or stroke, and need money to pay medical bills. In that case, you may be eligible to receive up to 100% of your policy’s death benefits.
Investopedia noted that these benefits were not exclusive to permanent life coverage and that many people could access them in other ways “without having to pay the high agent commissions or management fees that are associated with permanent life.”
What is the disadvantage of a permanent insurance policy?
The cost of permanent insurance is one of the significant drawbacks. The premiums are higher than for term life insurance. Tax implications can arise from permanent policies if beneficiaries choose to surrender coverage or if an insured dies with unpaid loans. Additionally, borrowing against the cash value and claiming accelerated benefits may reduce the payout.
Read more: Life insurance satisfaction is flat despite the pandemic – J.D. Power.
How do policyholders create wealth with life insurance?
In addition to receiving a death benefit, permanent life insurance policies allow policyholders to build up cash value. These funds can be used to pay premiums, get a low-interest loan, or supplement retirement income. According to Investopedia, insureds may also use the cash value of their policies to create an investment portfolio to maintain and accumulate wealth.
How do permanent life insurance plans accumulate cash value? Cash value is accumulated as premiums are divided into three parts, according to a financial website. The death benefit is one part of the premium, the operating costs and profit of the insurer are another, and the remaining amount goes to the cash value.
Investopedia stated that “the life insurance company invests the money in a conservative investment with a low yield.” As you pay more premiums and earn interest on your policy, the cash value will grow over time.
Over time, accumulation slows.
The website explained that in the first years of your policy, a more significant portion of the premiums will be allocated to your cash value account. In general, the cash value of a policy can increase quickly during the first years. As you age, your cash value will decrease, and the cost of insurance will increase.
Investopedia noted that the cash value accumulation varies by policy type. Whole life plans offer cash value accounts “that grow according to a formula determined by the insurance company,” while universal policies build cash value using current interest rates.
The table below shows how cash value builds up in a $100,000 entire life insurance policy, with premiums being paid by the insured male starting at age 35.
| Policy year | Age | Annual premiums | Cash value | Death benefit |
|---|---|---|---|---|
| 5 | 40 | $1,178 | $3,738 | $100,370 |
| 10 | 45 | $1,178 | $11,569 | $101,513 |
| 20 | 55 | $1,178 | $33,838 | $114,625 |
| 30 | 65 | $1,178 | $72,398 | $144,881 |
| 35 | 70 | $1,178 | $99,839 | $166,343 |
| 50 | 85 | $1,178 | $228,317 | $271,184 |
| 55 | 90 | $1,178 | $289,301 | $323,334 |
Source: Investopedia
The website advised that permanent life insurance policyholders should use the cash value accumulated in their plans instead of simply ignoring it.
The firm stated, “Don,’t waste the cash value you have built up on your policy; the cash value of your policy is returned to the insurer at your death, not to your heirs.”
