There are two main types of life insurance: term life insurance and permanent life insurance.
Term Life Insurance
For your typical family, term life insurance is the best option. Providers buy term life insurance for risk mitigation. Term life insurance can replace income should a provider die unexpectedly.
Term life insurance is the best option because it’s affordable. The monthly premiums can fit into family budgets.
Term life insurance is most often purchased to provide coverage during your working years and end when you reach retirement. Term life insurance does not accumulate cash value.
Permanent Life Insurance
Permanent life insurance is more expensive, but lasts the insured’s entire lifetime. It’s not temporary coverage like term life insurance. When the insured dies, the policy provides a death benefit.
Permanent life insurance does accumulate cash value. A portion of your policy’s premium goes into a cash value account. The amount earns interest and steadily grows. The longer you let it sit untouched, the more it accumulates due to compounding interest.
This cash value gives policyowners living benefits. One of the primary uses of these living benefits is supplementing retirement income.
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Benefits of Life Insurance in Retirement Planning
- If you die unexpectedly during your working years, the income tax-free death benefit provides money to your loved ones to pay bills.
- You can take loans out against the policy’s cash value account while you are alive and use the funds however you wish.
- You can make tax-free withdrawals of cash up to a certain amount from the cash value account while you are alive.
- When you die, the death benefit, minus any withdrawals or policy loans, will be distributed tax-free to your beneficiaries.
Unlike other sources of retirement income, such as IRAs, accessing the cash value of a permanent life insurance policy is not reported to any credit bureaus and there aren’t any tax penalties for early withdrawals.
Taking Out a Loan on Your Policy
You can take out loans against your policy’s cash value. You can think of it as borrowing from yourself.
The cash value account includes the portion of your paid premiums, along with any accrued interest those funds have earned. Typically up to 90% of the cash value can be borrowed against. But if the outstanding balance and accumulating interest ever exceeds the policy’s total cash value the policy will terminate.
The loan isn’t considered taxable income, but it does accrue interest similar to any other personal loan.
Loans decrease the amount in your cash value account which then slows its growth because compounding interest has less to work with. You can choose to pay back the policy loan during your lifetime, but it’s not required.
If you die before you repay the loan, the loan amount plus interest is subtracted from your death benefit before it’s paid to your beneficiaries.
Withdrawing Money from Your Cash Value Policy
You may be able to make a tax-free withdrawal from your permanent life insurance policy. But, if your withdrawal exceeds the amount you’ve paid so far into the cash value portion of your policy, it’ll be taxed as income.
Withdrawals are permanently subtracted from the policy’s value. You can’t pay it back, unlike policy loans. This means there is now less cash value left to earn dividends, accumulate, and borrow against.
A withdrawal also reduces the death benefit that’s paid out to your beneficiaries when you pass away.
Surrendering Your Life Insurance Policy for Its Cash Value
A surrender is essentially a cancellation of your policy (you’ll no longer be covered by life insurance).
When you surrender your life insurance policy, your equity is the amount you’ve paid into the cash value portion of your account plus accrued interest. However, if you have any loans or unpaid premiums on the policy the insurance company subtracts these amounts from the surrender value.
If you haven’t owned the policy very many years, you may need to pay surrender fees. Finally, you could also be charged income tax on the money you receive from surrendering the policy if amount exceeds premiums paid.
Using Cash Value to Pay Premiums
You may be able to use the cash value in your policy to help pay your life insurance policy’s premium. But keep in mind that if you deplete the funds in the cash value account entirely, it can cause your policy to lapse, which would end your life insurance coverage altogether.
Uses for Cash Value in Retirement
Supplementing retirement income for your own enjoyment is one way to use cash value. Maybe you want to spend your golden years in a beachfront condo.
Perhaps you want to leave something behind for your grandchildren for their college education.
Or maybe you wind up in a position where you need to fund care as your spouse’s health deteriorates.
If you’re concerned about spending down your assets during retirement, you can find yourself making difficult choices. Permanent life insurance can give you the flexibility to pay for what’s most important to you while you’re alive and the death benefit can replenish assets for your spouse to generate income, fund your legacy, or both.
Interested in buying permanent life insurance? Learn more by reading our guide on permanent life insurance. On this page you can also request a permanent life insurance quote. One of our advisors will reach out and can review your needs with you.
About the writer
Natasha Cornelius, CLU
Senior Editor and Licensed Life Insurance Expert
Natasha Cornelius, CLU, is a writer, editor, and life insurance researcher for Quotacy.com where her goal is to make life insurance more transparent and easier to understand. She has been in the life insurance industry since 2010 and has been writing about life insurance since 2014. Natasha earned her Chartered Life Underwriter designation in 2022. She is also co-host of Quotacy’s YouTube series. Connect with her on LinkedIn.