When to Buy a Cash Value Policy

Let me first reiterate and highlight the positive aspects of Cash Value polices.  As we have noted, Cash Value policies have two component parts: a life insurance element and the investment element.  If the insured person under the policy dies, the policy pays a death benefit that is the total of these component parts.  Remember I mentioned the tax advantages of life insurance policies:  if the policy matures and pays off by reason of the death of the insured, the entire death benefit is income tax-free to the beneficiary receiving those proceeds.  Thus, in the event of the death of insured, the cash value component of the policy is paid off tax-free whereas if the policy was simply cashed in by the owner without the insured dying, the cash value component in excess of premiums paid on the policy would be taxable.  Another tax advantage of a Cash Value policy if the insured doesn't die is that the cash value investment element grows tax-deferred like in the qualified retirement plans we analyzed earlier under Retirement Planning.  Not until the policy owner cashes it out is there taxable income to the extent the cash value exceeds the aggregate premium payments on the policy.

Therefore, Cash Value life insurance policies are frequently touted as a win-win investment that every American should have: if you die, the policy pays an income tax-free death benefit to your beneficiary; if you live and cash the policy out when you retire, you have another form of tax-deferred retirement income in addition to your IRA's and other qualified retirement plans.  Also, the insurance industry will frequently tout cash value policies as a form of forced savings.

Every one of these points is valid and true.  Why then do I recommend that the typical American not purchase Cash Value insurance to satisfy the majority of his or her life insurance needs?  Because there is frequently a better way to get the same results other than through the purchase of a Cash Value life insurance policy.  I will explain in detail what those better ways are in a moment.

However, before leaving this discussion, let me highlight those occasions and times when the purchase of a Cash Value policy does make great sense.  Even if you are most concerned about maintaining high amounts of Term life insurance during your working/child-rearing years, all Americans should plan on maintaining some Cash Value life insurance until they die.  For example, regardless of how much wealth you have accumulated in your retirement plans and otherwise, it is sound wisdom to have a ready source of tax-free cash available to your family to fund funeral expenses and other death costs as well as to provide for living expenses until your other sources of wealth can be systematically tapped.

Because Term insurance becomes prohibitively expensive as the insured ages, it is unrealistic to attempt to carry Term life insurance until the death of the insured.  But because of the ability to leverage the premium cost through the investment element, maintaining a life insurance policy until the death of the insured becomes much more feasible with a Cash Value policy.

What are some other situations when we can anticipate a need to maintain large amounts of life insurance until the insured dies?  The following situations involve facts and circumstances that generally will not be encountered by the typical American.  For example, if you are in the distinct minority of Americans who will be subject to a significant federal estate tax at your death, one of the ways of accommodating that ultimate estate tax liability is by getting a big slug of income tax-free life insurance proceeds on your death so that your estate has the cash liquidity to accommodate the death taxes.  In that situation, since you don't know whether you are going to die at the age of 60 or 100, the best way to assure that you have the necessary life insurance policy in force at your death is through a Cash Value policy.

Another situation that dictates the use of a Cash Value policy involves a profitable but closely-held (owned by only a few individuals) business.  Frequently in these enterprises, the owners agree in advance that on their death, the company will buy back their ownership interest.  The owners do this so that succeeding ownership can be restricted.

Example:  Owner A and owner B are happily working together.  However, if owner A dies, owner B does not want to be partners with owner A's widow or some other family member.  Owner A feels the same way with regard to owner B's successor.  So owner A and B agree between themselves that the first to die will contractually mandate his estate to sell his ownership interest in the business back to the company, typically at a predetermined price.  When one of the owners dies, the company now must come up with a large sum of cash to fund this extraordinary expense.  Usually the best way to accommodate this expense is through company owned life insurance on each owner's life.  When the first owner dies, the insurance company pays to the company (which is also the beneficiary under the policy) a large income tax-free death benefit to purchase the deceased owner's stock interest in the company.

If you do buy Cash Value insurance, plan on keeping it in force for at least 10 years.  Cash Value policies are heavily "front-end loaded" in order to pay the selling agent's commission and will accumulate little cash value in the early years of the policy.