Purchasing life insurance is always good for allied health professionals to consider to ensure those you love are taken care of if you were no longer here to provide consistent income. But before you purchase a life insurance policy, be sure you have an understanding as to what you are spending your hard-earned money on.
No all life insurance policies are the same. When a you are looking to purchase life insurance, differentiating between the different types available can be overwhelming. Its best to start with understanding that two major categories of life insurance exist: Term life insurance and permanent life insurance.
As if that weren’t complicated enough, then there are three different subtypes that make up the permanent life insurance category. The Insurance Information Institute, a United States association dedicated to expanding consumer knowledge of insurance, acknowledges the more common types of permanent life insurance to be whole life insurance, universal life insurance and variable life insurance.
In an effort to break down this complexity, this article will only focus on the similarities between the three subtypes of permanent life insurance.
Future articles will more specifically address the uniqueness of each subtype: whole life insurance, universal life insurance, or variable life insurance.
Let’s get started.
PROVIDING FOR YOUR HEIRS:
A death benefit is the amount paid out to the life insurance policy’s beneficiaries upon the death of the insured.
All permanent life insurance policies provide a death benefit to your beneficiaries upon your passing. This death benefit is a popular reason for purchasing a life insurance policy.
No Death Benefit Income Tax
Not only does a permanent life insurance policy provide your beneficiaries with a death benefit, but that money is also received tax-free.
PAYING FOR YOUR POLICY:
As described by Allstate Insurance Company, all permanent life insurance policies require that you pay premiums to keep the policy in force. The phrase “in force” is used to describe a policy that is still active. If a policy is no longer in force, then the policy is no longer maintaining an active status.
It’s important to know where your salary is going when you make these premium payments. Your payments are divvied up with a part of each payment allotted to the insurance company as a cost to maintain your policy (including your death benefit) while the rest is deposited an account called your cash value account. More on what a cash value account is later.
DURATION OF TIME THE POLICY LASTS:
Allstate also explains how all types of permanent life insurance can last until the policyholder passes away.
This is a characteristic unique to all permanent life insurance policies. It is beneficial because as you age and your health decline it becomes more expensive to be insured. You would expect this to be especially true for more physically taxing professions, such as physical therapy, occupational therapy and nursing, to name a few. This anticipated gradual decline in health is why every healthcare professional should also consider purchasing private long-term disability insurance early in his or her career.
With your policy already in force for your entire life, permanent life insurance lets you avoid worrying about having to qualify or re-qualify for a life policy that may become too expensive for you to purchase later in life. Just make sure to consistently pay the policy’s premiums to keep your policy in force so it does not lapse.
THE CASH VALUE ACCOUNT:
It Has a Cash Value Account
Permanent life insurance policies include an investment vehicle called a cash value account. This is why permanent life insurance policies are also referred to as cash value life insurance policies.
While the presence of the cash value account allows for the opportunity to increase the value of your whole life insurance policy over time, there are differences in subtypes to consider. These will be reviewed more closely when covering each of these subtypes individually: whole life insurance, universal life insurance, and variable life insurance.
Cash Value Account Grows Tax-Deferred
Like with most investments, the hope is that your cash value account will grow over time. As it does, much like 401(k) and IRA retirement accounts, your account will not be taxed.
Cash Value Account is Not Inherited
Even though your cash value account typically increases in value as time passes, the money in this account is not passed on to your beneficiaries in the instance of your passing – only the death benefit is. While The Guardian Life Insurance Company of America does take the time to explain this, this is a very important piece of information to be aware of as many insurance companies don’t readily advertise this.
ACCESSING MONEY FROM THE CASH VALUE ACCOUNT:
As healthcare professionals, we often see how the lives of our patients can change suddenly and unexpectedly. Unfortunately, this can happen to us as well. When such circumstances lead to financial disruption, there are two main ways you can access the money in your cash value account when needed:
1. Borrowing against your cash value account
2. Withdrawing from the account
Below are some quick facts about these two options:
Borrowing Against Your Cash Account
If you’re in need of money, you can borrow against your cash value account up to the value of the account.
This option can also sound appealing if you have difficulty qualifying for a bank loan, since you do not have to go through any application process or fulfill any requirements to borrow against your cash value account.
There are a few important details to be aware of before deciding to do this, though.
As described by Principal Insurance Company, if you choose to borrow money against your cash value account, you may do so without paying taxes even if the amount you borrow is greater than your cost basis.
Also, when you take out a loan against your cash value account, you have to pay back that loan with interest. Not only are you having to pay interest to borrow your own money, but that interest rate is usually fairly high compared to the current interest rates found elsewhere.
For example, The Massachusetts Mutual Life Insurance Company (Mass Mutual) advertises to expect a rate between 5-8%. This interest rate range brings back eerie memories of the interest rates on my physical therapy graduate school student loans. As we all know, this interest rate tacked on for borrowing against your cash value account can really begin to add on to the money owed if it is not paid back in a timely manner.
Finally, it is true that you do not have to pay back the loan. However, Principal further explains that if you don’t pay the loan back then the life insurance company will simply take it from your death benefit if you pass away. Since the death benefit is likely a big reason why you purchased a life insurance policy in the first place, this is not an optimal outcome.
Overall, as mentioned by Mass Mutual, the main advantage of having the option to borrow money against your cash value account is that it can be helpful in an emergency-type situation.
If you need money and the option of borrowing money against your cash value account doesn’t appeal to you, then you can opt to withdrawal money from your cash value account.
Unlike when borrowing against your cash account, when making a withdrawal, you don’t have to worry about paying this money back if you don’t want to.
However, Allstate points out how making a withdrawal from your cash value account can decrease the value of your death benefit.
You can even avoid being taxed on your withdrawn amount if that amount does not exceed your policy basis. Withdrawals that exceed your policy basis, though, do get taxed.
BUT WAIT, THERE’S MORE:
Option to Add Riders
As discussed with long-term disability insurance, you do have the option to purchase riders to supplement your permanent life insurance policy.
As State Farm Insurance Company advertises, some of these riders can help you prepare for a potential future hardship, such as ensuring that your premiums will be taken care of if you were to become disabled, while other riders provide you with an easier path to add on additional coverage as needed by forgoing the medical underwriting process again. The medical underwriting process is the medical examination an insurance company requires of a potential future life insurance policyholder to determine the extent of the applicant’s insurability
While some of the riders you may encounter sound enticing, companies like Guardian remind you that these do add additional cost to your policy.
Beware the Modified Endowment Contract Label
As Mass Mutual explains, before the 1980s, someone could purchase a permanent life insurance policy with a large single premium payment. Using this sizeable payment, the new policyholder could then invest that large amount of money into the policy’s cash value account, accumulate sizeable investment gains on a tax-deferred basis and then borrow against this increased amount of tax-deferred money without paying taxes and without having to pay it back until the policyholder’s death necessitated repayment being taken from death benefit. This means of investing a large amount of money and avoiding taxes was an especially appealing strategy since tax on capital gains during that time was nearly as high as 40%.
Today, the IRS requires that a permanent life insurance policy pass what is known as a 7-pay test in order to avoid being reclassified as a modified endowment contract (MEC).
The IRS’s 7-pay test calculates and enforces a limit on how much premium can be paid toward a permanent life insurance policy during the first seven years of policy ownership. In doing so, this limits the amount of money that can be placed into the cash value account during this timeframe, thereby preventing a large tax-deferred gain from occurring.
If the policyholder pays more than the allowed annual premium amount during any of these first seven years, then the permanent life insurance policy fails the 7-pay test and becomes a MEC. Once the policy is reclassified as a MEC, it must remain a MEC for good.
While a MEC still allows the money in the cash value account to grow tax-deferred, there are important differences when considering the withdrawing of this money.
For example, a permanent life insurance policy allows the policyholder to withdraw money up to the principal amount without enduring a tax, while any additional money withdrawn past this initial value is taxed. This is because the first money withdrawn from a permanent life insurance policy’s cash value account is considered to be the initial amount, termed the principal amount, of money placed into the account. This is known in the permanent life insurance circles as First In First Out (FIFO).
However, any money withdrawn from a MEC is taxed immediately because the first amount of money withdrawn from a MEC is considered to be the gains made from the principal amount rather than the principal amount itself. This is referred to as a Last In First Out (LIFO) set-up.
In addition to taxing any money withdrawn, if the policyholder withdrawing money from a MEC is younger than 59½ years old, that withdrawn money will also be subject to an additional 10% penalty.
Unfortunately, a new 7-year period begins any time a material change is made to your permanent life insurance policy. Such changes include adding a rider or increasing the policy’s death benefit.
OPTIONS TO GET RID OF YOUR POLICY:
Option to Surrender
If you purchased a permanent life insurance policy and you decide that you no longer want to keep that policy in force, you do have the option of ending it. Insurance companies such as Principal describe doing so as surrendering your policy.
Therefore, if you are unhappy with the policy you have, you don’t have to be stuck with it forever. Before making this decision, however, be sure to take into account several other key aspects:
First, as described by Nationwide Mutual Insurance Company, if you surrender your policy early in the life of your permanent life insurance policy, then you will incur a surrender fee. This early part of the policy’s life is referred to as the surrender charge period and it gradually decreases the longer you have had the policy until it no longer exists at all. Depending on the insurer, this typically occurs after owning the policy for a range of between ten to twenty years. For example, the table titled “Reductions to Surrender Charges” on page 14 on this prospectus from Nationwide outlines how the surrender charge eventually reaches 0% by year nine of policy ownership. Overall, if you do surrender your policy, you will receive the cash value of your policy minus the surrender charge.
Additionally, as noted by Principal, this amount you have left after paying the surrender fee minus the policy basis will be taxed.
Also, as mentioned earlier and as explained by State Farm, if you fail to pay back a loan when you surrender your policy, you can incur tax on the amount borrowed that is greater than your policy basis.
Finally, when you surrender the policy, Northwestern Mutual explains that you will no longer have a death benefit to leave to your beneficiaries upon your passing.
Option to Sell – Viatical Settlement
If you no longer want to own your permanent life insurance policy but you’d prefer to avoid surrendering your policy, another option is to sell it to a company that is looking to purchase your policy.
Such a company would then look to resell it to someone unable to qualify to purchase their own life insurance policy directly from a life insurance company. Individuals that find themselves in this predicament are typically anticipating a shorter life expectancy due to a terminal diagnosis.
Selling your policy in this manner is called a viatical settlement and can help both parties: the potential buyer can improve their ability to pay for anticipated medical expenses by receiving the death benefit while the current policyholder makes a better profit when compared to simply surrendering the policy.
Another bonus for the current policyholder is avoiding having to pay taxes on the profit made from the sale transaction.
Option to Sell – Life Settlement Option
You also have the option to sell your policy to an individual not suffering from a terminal illness. Doing so is referred to as a life settlement. However, unlike with a viatical settlement, you will incur tax on the profits made from the sale of a life settlement.
FINAL THOUGHTS. . .
Now that you are more familiar with the category of permanent life insurance, future articles will explore different types of permanent life insurance.
Do you have any additional information to share on the similarities found between permanent life insurance policies? Any questions on aspects that may not have been covered? Before moving on, please help make the Money Mobilizer a supportive and welcoming community for our current and future colleagues by leaving a question or sharing your knowledge below!