Cash Value Life Insurance
Distinct from Term life insurance are Cash Value life insurance policies. A Cash Value policy has two elements: death protection and an investment. As noted above, Term insurance only pays a benefit on the death of the insured (since it is only pure death protection). A Cash Value policy, however, is available to pay wealth to the owner of the policy to the extent of the investment component whether or not the insured under the policy has died. Cash Value policies generally go by many different names, with Whole Life, Ordinary Life, and Universal Life being the more common labels. The distinctions between these Cash Value policies are often blurred and the different characteristics of them sometimes are combined, but I'll give you some general points of reference.
Whole Life and Ordinary Life Insurance Policies
Under the more traditional version of this type of policy, there is a guaranteed, level premium for the entire life of the insured. The death benefit payable on the death of the insured often remains constant as well. The contract essentially has two component parts, decreasing term insurance and an increasing investment component: if the total death benefit remains constant at a $100,000, as the investment component of the policy increases the death protection component of the policy necessarily decreases. In the traditional version of this type of policy, a cash value is guaranteed in that the policy will "endow" at a sum certain at a given age (65 for ordinary life and age 100 for whole life) as long as the premiums are paid in full until that endowment date.
Policy Dividends Many Whole Life and Ordinary Life insurance contracts make a payment referred to in the policy as a "dividend." Dividends paid on life insurance policies are very different than true dividends paid to the stockholders of a company. Whereas dividends paid to the stockholders of a company are taxable income to the recipient stockholders, "dividends" paid to the owner of a life insurance policy are considered by the IRS to be a rebate of premiums. Therefore, life insurance dividends and cash value withdrawals on a partial surrender of the policy are a tax-free return of some of the original premium costs of the policy. This tax-free treatment of life insurance dividends continues until the cumulative insurance dividends exceed the aggregate premium payment over the life of the policy. It is rare (at least for a number of years) that total policy dividends paid exceed total policy premiums and, therefore, the dividends paid to the policyholder usually are tax-free. NOTE: Despite this general tax-free treatment of life insurance dividends, the insurance company might send you a Form 1099-DIV (generally associated with taxable dividends). Again, unless total cumulative policy dividends have exceeded total premiums paid over the life of the policy, you can ignore this Form 1099-DIV and treat the dividend as a tax-free return of your investment in the policy. As an alternative to these tax-free policy dividends being paid to you in cash, another option typically offered under the policy is to utilize the policy dividends to buy "paid-up additions." Under this option, a small amount of fully paid-up insurance is purchased as each policy dividend is declared under the basic policy. These paid-up additions themselves may accumulate an additional cash value and/or pay an additional small dividend yield. Another variation on this theme is the so-called "disappearing premium" policy. With certain of the better mutual life insurance companies, the policy might be structured in a way that after the initial years of policy maintenance the dividend yield off the policy will be sufficient to cover the entire annual premium cost. Under this type of policy design, premium costs in the earlier years of the policy are somewhat inflated such that the dividend yield off the policy by later years (9 to 20 years later depending on the company and policy design) is sufficient to cover the ongoing premium costs thereafter. Remember, however, that if the cumulative dividend return exceeds the aggregate premiums actually paid on the policy in its later years, the excess dividends will be included in the policy owner's income. This type of policy is a very good choice to the extent that maintenance of a larger amount of insurance until the death of the insured is desired. I will talk about when this makes sense under the section on Shopping for Insurance. However, for most of us buying large amounts of insurance and keeping it in force until the death of the insured is not a good idea. Yet, even for those of us of modest means it will make sense to maintain some life insurance coverage until mortality to cover funeral and other death expenses. But it is often prohibitively expensive for typical Americans to maintain large amounts of coverage until they die. Rather, for the typical American, insurance should be maintained in significant amounts during those years when he or she is most in need of insurance-when there are children in the household and the income generated by one or both parents is necessary to get those kids through their college years.
Policy Dividends
Many Whole Life and Ordinary Life insurance contracts make a payment referred to in the policy as a "dividend." Dividends paid on life insurance policies are very different than true dividends paid to the stockholders of a company. Whereas dividends paid to the stockholders of a company are taxable income to the recipient stockholders, "dividends" paid to the owner of a life insurance policy are considered by the IRS to be a rebate of premiums. Therefore, life insurance dividends and cash value withdrawals on a partial surrender of the policy are a tax-free return of some of the original premium costs of the policy. This tax-free treatment of life insurance dividends continues until the cumulative insurance dividends exceed the aggregate premium payment over the life of the policy. It is rare (at least for a number of years) that total policy dividends paid exceed total policy premiums and, therefore, the dividends paid to the policyholder usually are tax-free.
NOTE: Despite this general tax-free treatment of life insurance dividends, the insurance company might send you a Form 1099-DIV (generally associated with taxable dividends). Again, unless total cumulative policy dividends have exceeded total premiums paid over the life of the policy, you can ignore this Form 1099-DIV and treat the dividend as a tax-free return of your investment in the policy.
As an alternative to these tax-free policy dividends being paid to you in cash, another option typically offered under the policy is to utilize the policy dividends to buy "paid-up additions." Under this option, a small amount of fully paid-up insurance is purchased as each policy dividend is declared under the basic policy. These paid-up additions themselves may accumulate an additional cash value and/or pay an additional small dividend yield.
Another variation on this theme is the so-called "disappearing premium" policy. With certain of the better mutual life insurance companies, the policy might be structured in a way that after the initial years of policy maintenance the dividend yield off the policy will be sufficient to cover the entire annual premium cost. Under this type of policy design, premium costs in the earlier years of the policy are somewhat inflated such that the dividend yield off the policy by later years (9 to 20 years later depending on the company and policy design) is sufficient to cover the ongoing premium costs thereafter. Remember, however, that if the cumulative dividend return exceeds the aggregate premiums actually paid on the policy in its later years, the excess dividends will be included in the policy owner's income. This type of policy is a very good choice to the extent that maintenance of a larger amount of insurance until the death of the insured is desired.
I will talk about when this makes sense under the section on Shopping for Insurance. However, for most of us buying large amounts of insurance and keeping it in force until the death of the insured is not a good idea. Yet, even for those of us of modest means it will make sense to maintain some life insurance coverage until mortality to cover funeral and other death expenses. But it is often prohibitively expensive for typical Americans to maintain large amounts of coverage until they die. Rather, for the typical American, insurance should be maintained in significant amounts during those years when he or she is most in need of insurance-when there are children in the household and the income generated by one or both parents is necessary to get those kids through their college years.
Universal Life Insurance Policies
Another broad category of Cash Value life insurance policies are called Universal life insurance policies. These policies, like Ordinary and Whole Life policies, have a cash value element as well as a life insurance element. Unlike Ordinary or Whole Life policies, this category generally pays little or no policy dividend.
At the inception of the policy, the policy owner is expected to pay a level annual premium to fund the life insurance and cash value buildup under the policy. After the policy has been in force for a while and the cash value element has built up sufficiently (usually a year or two), the total death benefit under the policy typically starts getting bigger. Instead of continuing to pay the annual premium and allowing the death benefit to get bigger, the policy owner has the option of reducing the annual premium costs. The trade off would be that if the annual premium costs were reduced, the death benefit under the policy that had been increasing would either level off or reduce. Some years the policy owner might pay the full annual premium. Other years the owner might reduce or not pay any annual premium on the policy.
What is happening in the years when the annual premium is not being paid is that the cash value under the policy is being tapped to pay that premium. This scenario can't be maintained indefinitely: if cash values aren't accumulating sufficiently, the owner ultimately will be unable to maintain the policy in this manner.
Investment Options in Cash Value Policies
Sometimes the owner of a Cash Value life insurance policy will have optional investments available for the cash value accumulating within the policy (the policy might be referred to as a "variable" life contract). One option might provide a lower but guaranteed rate of return (maybe in the 3% range). However, the upside rate of return on this type of investment option would generally be limited. This choice might, therefore, provide a rate of return similar to a long-term government bond and might appeal to someone who is generally risk adverse over the long-term per our earlier Retirement Planning discussion of risk tolerance (see page 93). Another choice to the owner of a Cash Value policy might be a portfolio of stock mutual funds. There is no guaranteed rate of return but the investment element has the ability to obtain more of a higher (but riskier) stock market rate of return. Here the owner needs to be less risk adverse. Again, we are looking at the same risk-return dichotomy that we studied earlier under our general Retirement Planning Base risk analysis.
Thus, if I direct the policy cash values to be invested in stock mutual funds, I can obtain a stock market rate of return. In the event that I die, the policy beneficiary would get the death proceeds under the policy as income tax-free life insurance proceeds even though that death benefit is comprised of the cash value element that was invested in stock mutual funds that would normally be a taxable investment. These facts are potent ones that are used to market Cash Value life insurance policies. One problem with investing in stock mutual funds available through life insurance contracts might be the administrative expense – the expense ratios and other costs might be relatively high.
As with Ordinary and Whole Life insurance, the purchase of Universal life insurance makes more sense as an insurance option for our long-term, relatively permanent, insurance needs.
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