Did Your Parents Give You a Whole Life Insurance Policy? Here's What to Do With It.
For many of us 30-somethings (and some of us both younger and older), our parents took out whole life insurance policies for us when we were kids. When we became income-earners and were deemed responsible enough, a ceremonious transfer of papers occurred, where we were told gravely that this policy is to be kept paid up, as it will be worth a lot of money. Sometime.
What is this insurance all about? Why will it be worth a lot of money? Should I just cancel it and take the cash? Or is there something else I don’t know?
If you have any of these questions, read on. You may discover that your whole life insurance policy is worth much more than you thought. (See also: Is Getting Life Insurance for Your Children Prudent or Prudish?)
What is Whole Life Insurance?
Whole Life is a type of permanent insurance. It combines a basic life insurance component with a cash (or dividend, or investment) component. Even though it is a permanent policy though, most are structured so that you only have to make premium payments for a temporary time (in the case of the policy your parents got you when you were still crawling, probably something like 20 or 30 years).
Each year from the time the policy is born, the insurance company pays out dividends. And like any dividend, these dividends represent a share of the insurance company’s profits. Those dividends are squared away into the cash component of the policy, and allowed to compound in growth by earning more dividends and interest income yet. The larger your cash value, the larger the annual dividends will be. So it stands to reason that as long as the policy’s projected dividends pay out, there could be a lot of cash in there when you reach retirement age. Heck – even in your thirties, you could be receiving policy statements showing you thousands of dollars in the “cash surrender value”. By the time you reach retirement, it could be close to $100,000.
(I must also note that in the 1980s, there were a series of policies sold by unscrupulous insurance agents who promised dividend payouts that were unrealistic. This sparked a whole life insurance scandal and a small fall-out in the industry. Today, whole life insurance policies are still very much viable products, as projections are more closely monitored so that policies are not sold with unrealistic expectations).
Why do premium payments stop?
Your policy is probably structured so that you won’t have to pay premiums after a while. Maybe the premiums stopped before you even inherited the policy from your parents. But the life insurance part is still there, and the investments keep growing. How is this?
The premiums are stopped under the “premium offset” option. Once the cash value is big enough, the dividends and interest income it earns each year is more than sufficient to cover off the life insurance premiums, with some left over to still be invested in the cash value. One the policy reaches this state of maturity, you can opt to offset your premium so you don’t have to fork over your own cash any more. This does, of course, make the cash value grow a little more slowly.
Why did my parents get me a whole life insurance policy?
Your parents may have bought you this policy for a few reasons.
- They are guaranteeing your insurability. If, during your upbringing, you contract an illness that affects your ability to get life insurance for the rest of your life, your parents will already have jumped the gun by getting you this policy. (Cash value aside, let’s not forget that a whack of cash is paid out in the form of life insurance when you die).
- The cost of whole life insurance for a child is cheap, and never increases.
- The cash value is intended to be a nest egg for you.
I need cash now. Do I cancel the policy?
No! First of all, you parents could very well have you drawn and quartered if you cancel the policy before it reaches “maturity” – which in their eyes means a hefty cash value, probably projected to happen when you reach retirement.
If you need cash now, there are a few ways to accomplish this while still keeping the policy alive. The best way is through doing a policy loan, which we’ll describe shortly.
I really can’t afford the premiums right now. Do I cancel the policy?
No! If you are sinking under the weight of still paying premiums, again you may be tempted to cancel the policy, with the promise of not only a reprise from monthly payments, but also a wad of cash being handed to you. Again, I urge you to consider other options, discussed below.
What happens when I cancel a whole life insurance policy?
Okay, here’s why you don’t cancel your policy:
- Your life insurance coverage stops. For good. You can’t change your mind and get it back. Getting new insurance at your age will cost exponentially more – and that’s if you are healthy and fit. If you have an illness that affects your insurability, you could be outright rejected.
- You are over the curve of payments. By the time your parents give you the policy, most of the hard work is done. All the policy really needs now is time, for the cash value to grow and compound – tax-free I might add. If you throw in the towel now, all your parents’ hard-earned payments towards your future are wasted.
- You’ll get the cash surrender value paid out to you. This is the beautiful carrot, which dangles in front of you each time you receive a statement, and are hard-up on cash. But this cash value paid out to you is also fully taxable. If the insurance company doesn’t withhold tax off the top (and even if they do), expect to end up paying extra when you file your taxes.
Okay, I won’t cancel my policy. But can I make withdrawals from the cash part?
No! (Well, yes, but really – you shouldn’t). For the same reason that you will get a tax bite from canceling your policy, making a direct withdrawal from the cash portion is costly in the form of tax. And since you are already earning an income through work, you will be taxed at your marginal rates, which could be high. Just…don’t go there.
How do I stop paying premiums now?
If you are hard-up for cash and want to know your options, call the insurance company, asking about a “premium holiday” or “premium offset” option. They will run the numbers on your policy as it stands today, and if there is enough money in the cash value and annual dividend payments to pay the premiums for you, they can arrange to do so.
It is ideal to ensure that your cash value is large enough that it won’t erode with ongoing premium payments, since that would mean eventually you will have to start paying premiums again, and that the compound growth of the cash value will be severely affected. It is quite counterproductive, but possible; depending on your situation, you will know if it is necessary.
How do I access the cash part without the tax bite or canceling the policy?
Ah, here is the fun part. You need money, but your parents will kill you if you cancel the policy. Or let’s say you’ve been a good child, paid all the premiums, let the policy grow to maturity, and now you are ready to do something with it. If you play your cards right, you can access the cash value – which has grown and compounded tax-free – without paying a dime in tax when you pull it out. Let’s repeat: You just invested money tax free, and pulled it out…tax free. This is why some whole life (or permanent) policies are worth their weight in gold.
Your ticket to such a loophole comes in the form of a “policy loan”. You aren’t actually making a withdrawal from the policy; instead you are borrowing against the cash value. The insurance company will usually arrange this for you, and at favorable interest rates too.
Let’s say you have a cash surrender value of $30,000. In order for the loan to work, they cannot lend you the entire amount though. They will lend you an amount large enough so there is enough money left in the policy such that the cash plus annual dividends can cover your loan payments (or at least the interest owing on the loan, if you can get an interest-only payment option) over the projected time of the loan. In some cases, the bank will simply accrue the interest payments to the loan amount itself, using your policy as collateral; allowing your cash value to continue to grow as if nothing happened. To do this though, the insurance company needs to be conservative enough to allow for interest rate increases so your policy doesn’t lapse over the term of the loan if prime rate goes up.
So they will lend you, say, $20,000 (for argument’s sake. Factors that go into calculation include your age, the size and terms of the policy, and the performance of the cash value to date. The older you are, the more money you will get as a percentage of the total cash value).
When you die, the insurance company (or bank) gets the money owed to them from the loan (plus interest, if it wasn’t paid with annual dividends), and the rest of the cash plus the insurance component is paid to your beneficiaries.
This policy loan strategy works well as a way to supplement retirement income in a tax-free fashion. Instead of taking out a lump sum loan, you can opt for annual loans to supplement your retirement income. Or you can pull out the lump sum and invest it elsewhere, if your income and tax situation allows for it. If you can hang in there until retirement, this whole life policy that your parents bought can be a great investment for you; a big help and an alternate nest egg.
Note of caution: Although the policy loan strategy is a viable one, it is not without risks. The bank could call the loan at any time – a risk with pretty much any loan. If such an event could financially cripple you, then you may wish to reconsider the amount of the loan, or whether it is worthwhile to take the loan out at all. Although it is a remote risk, it is worth mentioning.