July 3, 2012

Whole Life Policies: Tapping Cash Value as Alternative to Equity Investing

Whole life insurance policies have taken the spotlight as investors seek secure investment alternatives to today’s rocky equity markets. Not only do these policies provide for tax-deferred growth, but they come with many of the guarantees sought by clients today.

The market for these policies is soaring, as clients see them as vehicles allowing for a return on their investment in the life insurance contract without the risks inherent to investing in the open markets. An advisor’s guidance can be critical in determining whether a whole life policy is a smart investment for any given client and can also provide invaluable in navigating the often-complex rules governing the tax treatment of these policies.

The Resurgence of Whole Life Insurance

The stock market losses sustained by your clients in the past few years have them scrambling for alternative investment avenues. They simply are not willing to continue to risk their savings in what is often perceived as a volatile (and hostile) investing environment. A whole life insurance policy may provide a safe long-term investment because the investment in the contract grows tax-deferred and often at a guaranteed rate regardless of how the stock markets are performing.

At its most basic level, a whole life insurance policy requires that an investor pay a level premium each year, and provides for a guaranteed death benefit on the death of the insured. However, these policies also contain an investment component. A portion of the premiums paid is invested by the company issuing the policy, building cash value in the policy that the insured can borrow against.

Further, many of these policies pay an annual dividend, which is sometimes set at a guaranteed rate over the life of the policy and can be as high as 6% per year. These guaranteed dividends make whole life policies attractive for many investors looking for an income stream from their investments.

It is important to note that a whole life policy is a long-term investment—it may be necessary to pay premiums over a period of 15 to 20 years in order to realize a decent return on the investment.

Accessing the Cash Value of the Policy: Tax Implications

The advice of a financial advisor is critical in determining if and when withdrawing against the cash value of the policy is a smart choice. In general, the policyholder can borrow against the accumulated cash value without paying taxes or interest on the amount withdrawn. Of course, there are exceptions and consequences that must be considered when making these withdrawals.

Any withdrawals that are not repaid before the insured’s death will reduce the death benefit payable on the policy, so if the policy is purchased primarily to provide for the policyholder’s beneficiaries, withdrawals may not always be appropriate.

Despite the general rule, withdrawals are sometimes taxable. For example, if the withdrawal is made during the first 15 years of the policy’s existence and reduces the death benefit payable, the amount may have to be included in gross income. Any withdrawal that exceeds the taxpayer’s basis in the policy will be subject to income taxation.

In some cases, if the withdrawal is for more than the policy’s cash surrender value, the insurer can increase the premiums required to maintain the same death benefit under the policy. A substantial increase could cause the policyholder to have trouble meeting premium payments, in which case the policy would lapse and the investment could be lost.

Conclusion

For those clients who continue to shy away from equity investing, a whole life insurance policy can provide a viable alternative by offering guaranteed dividends and tax-deferred growth. It is, of course, important to examine each client’s financial position to determine whether the long-term investment required in the way of annual premiums is the best option in any given situation.

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For additional coverage of this issue and similar ones, we invite you to sign up with AdvisorOne’s Summit Business Media partner, National Underwriter Advanced Markets, for a free trial.

You may also be interested in signing up for a free trial with another Summit Business Media partner, Tax Facts Online.

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