Should I use my life insurance policy’s cash value for a down payment on a house?
If you’re reading this, there is a good chance you’re a high net worth individual or a high-income earner who wants to protect their loved ones. Maybe you’re married, have children or grandkids, or someone else who you want to take care of after you pass. If all the above is true, I’m sure you’ve looked into purchasing a life insurance policy.
There are two types of life insurance: term vs. permanent. As the name suggests, term life insurance expires after a set period. That amount of time is decided on by the insurance company and is based on factors like your age and health. On the other hand, permanent life insurance policies provide coverage for your entire life.
Deciding between a term or permanent life insurance policy depends on your age and financial goals. Each has their own advantages and disadvantages but in general, term insurance is useful for those with shorter-term needs, whereas permanent coverage is useful in long-term financial strategy.
Since permanent life insurance is meant to provide for you for the rest of your life, it has two types of value: the death benefit and its cash value. The death benefit of a life insurance policy is the amount that will go to your loved ones after you pass. The cash value has a bit more nuance in how it can be used.
With each premium payment towards your permanent life insurance policy, the money is split in three ways: to the insurance company, to your death benefit, and to the policy’s cash value. The cash value is usually invested into a low-risk investment account. With each payment, this value grows and grows.
Below are two examples of when permanent life insurance might be beneficial for you:
40-year-old high net worth individual with a family: Term & Permanent Life Insurance combination
Term insurance provides affordable coverage so that you can protect your family while still covering other financial obligations (mortgages, education, etc.).
With their lower premiums, you could invest the money saved into outside, higher-yield investment accounts for potentially bigger returns.
A term policy with a convertibility clause allows you to switch to a permanent policy at a later time.
Then, the permanent insurance offers lifelong coverage and includes cash value growth and estate planning benefits.
50 to 70 year old interested in multi-generational planning: Permanent Life Insurance
Provides a guaranteed death benefit.
Estate planning benefits - offsets potential estate taxes and preserves wealth for heirs.
Cash value - provides an additional source of tax-deferred savings that can be used during retirement (especially useful if other tax-advantaged accounts are maxed out).
Permanent life insurance includes whole and universal life policies. (For the purposes of this article, we will not dive into variable universal life policies). Whole life insurance provides a fixed death benefit and builds cash value at a guaranteed rate. These typically have higher premiums, but they remain level throughout your life. Universal life insurance has more flexibility in its premiums and death benefits. While it also builds a cash value, the growth rate is not guaranteed but is based on interest rates and investment performance.
Most people purchase life insurance with the goal of providing for their loved ones after they pass. However, the cash value in permanent life insurance provides more flexibility during your lifetime. You can extract this cash value, accessing funds that have built up with each premium. The amount you can access depends on the policy’s terms and the total accumulated cash value.
The cash grows tax-deferred, so you don’t pay taxes on it until you withdraw from it. Sometimes withdrawals are tax-free, again depending on your policy’s terms.
How is it possible to extract cash from a policy? There are three ways to do so: as a loan, withdrawal, or by surrendering.
Loan: You can borrow against the policy’s cash value, and the loan is typically paid back with low interest rates. Credit checks are usually not required. The loan and any accrued interest will reduce the death benefit if not repaid.
Withdrawal: You can take a portion of the cash value directly from your policy without paying it back. However, this may reduce the death benefit.
Surrender: This is completely cashing out the policy and receiving the full cash value. This cancels your life insurance coverage.
When is it a good idea to extract cash from my life insurance? Extracting cash can be useful, but only when it makes sense with your long-term financial goals.
One common time to take cash out is during retirement. If you’ve accumulated significant cash value, you can use it as supplemental income during retirement.
Another reason is to pay for major expenses. Whether for a home renovation, healthcare costs, education, etc., tapping into your cash value can help you manage large expenses without using other savings.
Lastly, people can use their cash value in case of financial emergencies. A life insurance loan can be a quick and relatively low-cost option to cover unexpected emergency expenses.
You might be hoping to purchase a second home and are wondering, should I use my life insurance policy’s cash value for a down payment on a house? The answer will vary depending on how you extract the cash value, whether you’ve looked at other financing options, and the long-term impact.
Loans and withdrawals are the most common ways to extract cash because they keep your policy in force. If you take a loan against your policy, you may have to repay it with interest, which could affect the future cash value and death benefit. On the other hand, if you make a withdrawal, it could reduce your policy’s growth potential.
While it might seem logical to take a loan from your own cash value, other funding options might have more advantageous terms. A few other options are personal loans, home equity loans, or government-backed mortgages.
Using your cash value for a down payment could lessen the policy's value so if you want your beneficiaries to have the full death benefit, using the cash value now might not make sense.
Life insurance does exist to provide for loved ones after you pass, so you should not purchase a policy with the single goal of extracting from its cash value. Because the cash value is invested in a low-risk account, ROI is likely to be higher through investments in high-yield accounts.
Cash value is most helpful for unexpected costs or wanting to use your cash without making withdrawals from other savings accounts.
One of the main advantages of the cash value is that it grows tax-deferred. However, taking out the cash value has tax implications which vary depending on how you access the funds.
Loans are usually not taxable if the policy remains in force and if it’s less than your paid premiums. Withdrawals are tax-free up to the amount of premiums you've paid. Anything beyond that is subject to income tax, since it is considered a return on investment. Lastly, if you surrender to cash out the entire policy, any amount above your cost basis is taxable.
Extracting cash value from your policy can be a useful strategy in your financial planning. It can be a source of tax-advantaged funds, provide supplemental retirement income, and be used for unexpected expenses. However, this should only be done after considering its full implications.
As always, we recommend working with a tax professional who understands both tax strategies and wealth management.
Author: Rob Cucchiaro, CFP®, CRPC, AAMS
Questions answered in this article:
What is the difference between term and permanent life insurance?
When I make a premium payment to a permanent life insurance policy, what does that money go to?
What types of permanent life insurance are there?
How much of the cash value in my permanent life insurance policy can I withdraw?
When I withdraw from my permanent life insurance policy will I owe taxes on it?
What are the ways I can withdraw cash from a cash value in a life insurance policy?
When is it a good idea to extract cash from my life insurance?
Should I use my life insurance policy’s cash value for a down payment on a house?
Is it better to invest in a premium life insurance policy or in a regular investment account?