Accessing The Cash In Your Life Insurance Policy

Retirement Income Planning, Calgary

The year was 1993 we were in desperate need of new car. We were turned down for financing at the bank. Probably had something to do with my $230/week salary. A friend of Nancy’s parents had this really nice 1989 Pontiac 6000 with low milage. An amazing upgrade from our rusting 1984 Buick Skylark that I had spent more money on spray paint than gasoline trying to make it look respectable.

We were able to fetch $1100 for our beater and we borrowed $3900 from my father in law’s cash value whole life insurance policy. No questions asked by Sunlife, no qualifying, no set prepayment terms and at a reasonable interest rate.

We jumped at the opportunity and were soon sporting around in our new ride.

In tough economic times, you are sometimes left scrambling for cash to meet everyday expenses and lifestyle demands. Your life insurance policy can be a possible source of funds – but should you tap into it?

There are certainly pros and cons so let’s examine some of your options.

Methods of Accessing Cash:

Cash-value life insurance, such as whole life and universal life, builds reserves through excess premiums plus earnings. These deposits are held in a cash-accumulation account within the policy.

Cash-value life insurance offers the opportunity to access cash accumulations within the policy through withdrawals, policy loans, or partial or full surrender of the policy.

Be sure to keep in mind that although cash from the policy might be useful during stressful financial times, you could face unwanted consequences depending on the method you use to access the funds.

Withdrawals

Generally, it is possible to withdraw limited amounts of cash from a life insurance policy. The amount available differs based on the type of policy you own and the company issuing it. The main advantage of cash-value withdrawals is that they are not taxable up to the adjusted cost base of the policy. The exact details can be found out by contacting your insurance company.

However, cash-value withdrawals can have unexpected or unrealized consequences:

Withdrawals that reduce your cash value could cause a reduction of your death benefit – a potential source of funds you might need for income replacement, business purposes or wealth preservation.

Cash-value withdrawals are not always income-tax free. For example, if you take a withdrawal during the aerly years of the policy and the withdrawal causes a reduction in the policy's death benefit, some or all of the withdrawn cash could be subject to taxation.

Withdrawals are treated as taxable to the extent that they exceed your cost basis in the policy.

Withdrawals that reduce your cash surrender value could cause your premiums to increase in order to maintain the same death benefit; otherwise, the policy could lapse.

Loans

Most cash-value policies allow you to borrow money from the issuer using your cash-value accumulation account as collateral. Depending on the terms of the policy, the loan might be subject to interest at varying rates; however, you are not obligated to financially "qualify" for the loan. The amount you can borrow is based on the value of the policy's cash-accumulation account and the contract's terms.

The bad news is that loan balances generally reduce your policy's death benefit, meaning your beneficiaries might receive less than you intended. Also, an unpaid loan that is accruing interest reduces your cash value, which can cause the policy to lapse if insufficient premiums are paid to maintain the death benefit. If the loan is still outstanding when the policy lapses or if you later surrender the insurance, the borrowed amount becomes taxable to the extent the cash value (without reduction for the outstanding loan balance) exceeds your adjusted cost basis in the contract.

One other option available to you is to use the policy’s cash value as collateral at a bank. Typically, any Bank in Canada will loan you up to 90% of the cash value within your policy. The bank loan can be repaid at any time or out of the proceeds of the insurance policy upon your death. Keep in mind that interest will be accruing on the loan. There are no tax consequences with this option.

This strategy can be used to pay for long term care cost as you age. If you have a significant cash surrender value built up in your policy you can use the value as collateral and take out a loan at a bank to pay for the cost of long term care. This would be your best course of action as the loan proceeds would not be included as income and have an impact upon any other government benefits such as OAS clawback.

Surrender

In addition to withdrawals and policy loans, you can surrender (cancel) your policy and use the cash any way you see fit. However, if you surrender a Universal Life policy during the early years (10 years) of ownership, surrender fees will likely be charged by the company, reducing your cash value, often to near zero. These charges vary depending on how long you've had the policy. In addition, when you surrender your policy for cash, the gain on the policy is subject to income tax, and if you have an outstanding loan balance against the policy, additional taxes could be incurred. Again, the insurance company can provide you with a breakdown as to the taxable portion to you, so you can decide if it’s a good idea.

Although surrendering the policy can get you the cash you need, you're obviously relinquishing the right to the death-benefit protection afforded by the insurance. If you want to replace the lost death benefit later, it might be harder or more expensive to get the same coverage. The cost of life insurance is based on your age, health and smoking status. Load up on the stuff when you are young and healthy.

The Bottom Line

Financial hardships can tempt you to liquidating assets for cash. Sometimes you might have no other choice, but when it comes to life insurance, think about why you purchased the policy in the first place. Do you still need the coverage? Are the policy's beneficiaries depending on the death benefit if something happens to you? What are the tax considerations with each option?

You should also consider other alternatives before using your life insurance policy for cash. Taking out a home-equity loan, emergency savings, selling unneeded junk around the house, sending your teenagers out to work etc. Short of winning the lottery, none of these options comes without  consequences, but based on your current needs and financial circumstances, some choices might be better than others.

Book an introductory meeting in our calendar below and we'll help you get clarity around your goals and values and complete a one page financial summary. We'll show you how a written financial and investment plan will help you reach your goals and retire ready.

Read more: "4 Common Retirement Mistakes Young Couples Make"

 

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Your Trusted Advisors,

Willis & Nancy

 


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