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Life insurance is an integral part of financial planning for about 52% of Americans. When opting for life insurance, it is critical to understand all the features and options available in a policy. Among these is the concept of liquidity and its importance in a life insurance policy.
The primary purpose of life insurance is to provide for loved ones after the policyholder’s death. However, some life insurance policies boast a cash value feature in addition to the death benefit. In a basic sense, the insurer sets aside a portion of the premiums into a cash account or invests the money in stocks, bonds, or mutual funds.
The cash account grows over time, and the policyholder can borrow money from it or withdraw funds subject to terms and conditions. The ease with which the policyholder can access these funds while still alive is what insurers refer to as liquidity.
This article looks at liquidity in life insurance policies and how it can benefit policyholders.
Bottom Line Up Front
Liquidity in life insurance is the ease with which a policyholder can access their policy’s cash value. Most life insurance policies have some form of liquidity, but whole life and universal life policies have the most. The cash value is subject to market fluctuations, so policyholders must be aware of the risks involved.
What Is Liquidity and Why Is It Important?
The general financial definition of liquidity is the ease with which an asset can convert into cash without losing significant value. Business owners often use this term to describe the company’s ability to pay short-term debts and obligations with current assets.
Liquid financial assets impact a company’s solvency and ability to continue operating. The same principle applies to individuals. Personal liquidity is the number of liquid assets an individual has available to them at any given time. It is a crucial factor in financial planning and can be used to cover short-term expenses, such as car repairs or medical bills.
Some common examples of liquid assets include:
- Cash
- Checking and savings accounts
- Money in a short-term savings account or certificate of deposit (CD)
- Treasury bills
- Mutual funds
- Stocks
Examples of assets that are not liquid include:
- Real estate
- Precious metals
- Cars
- Private businesses
Liquidity in the Context of Life Insurance
When defining liquidity in life insurance, two crucial terms come into play.
- Death benefit
- Cash value
The death benefit is the amount of money paid to the beneficiary of a life insurance policy upon the insured’s death. In contrast, the cash value is the amount of money set aside by the insurer that the policyholder can access while still alive.
Some life insurance policies have a death benefit and cash value, while others only have the death benefit. The cash value of a life insurance policy grows over time and is determined by the insurer’s investment performance. The policyholder can borrow money from the cash value or withdraw funds, reducing the death benefit.
How to Access Cash Value of a Life Insurance Policy
There are a few ways to withdraw cash value from a life insurance policy.
- Withdrawing cash: The policyholder can withdraw cash from the policy’s cash value. The withdrawal amount should not exceed the cash value because it will be considered an income subject to taxation.
- Taking a policy loan: The policyholder can take out a loan against the policy’s cash value. The loan amount will accrue interest, and the policyholder will need to repay the loan plus interest. The internal revenue service doesn’t consider the loan amount an income. Hence it won’t be subject to any form of taxation.
- Paying premiums with the cash value: Policyholders can pay their premiums with their cash value. This is only an option if the cash value is greater than the premium amount. The insurer will deduct the premium amount from the cash value, and the policy will continue to stay in force.
- Cashing out the policy: The policyholder can surrender the policy to the insurer and receive the cash value as a lump sum. The policy will no longer be in force, and no death benefit will be paid out. A surrender fee also applies, which also reduces the policy’s surrender value.
Types of Life Insurance Policies with the Most Liquidity
Permanent life insurance policies that have the highest level of liquidity include;
- Whole life insurance
- Guaranteed universal life insurance
These policies have a death benefit and cash value. The insurer keeps the cash value in an account that accrues interest and is easy to withdraw. However, the cash value is subject to market forces.
The main difference between the two policies is that whole life insurance has a fixed premium for the life of the policy, while guaranteed universal life (GUL) insurance premiums can increase or decrease over time. GUL insurance also offers more death benefit flexibility than whole life insurance.
Other policies that may include a cash value include;
- Variable universal life insurance
- Indexed universal life insurance
These policies have a death benefit, cash value, and investment options. The cash value in indexed universal life insurance is based on the performance of an index, such as the S&P 500.
Variable universal life insurance offers more flexibility than indexed universal life insurance because the policyholder can choose the investments that make up the cash value. However, this also means the cash value is subject to market conditions and can lose value.
Why Term Life Insurance Doesn’t offer Liquidity
Term life insurance is a policy that only has a death benefit. The policy does not have a cash value, and the premiums are fixed for the life of the policy. This type of insurance is ideal for people who need coverage for a specific period, such as 10, 20, or 30 years.
Term life insurance doesn’t have liquidity because it is a temporary policy. The policy expires once the term is up, and no death benefit is paid out.
While term life insurance doesn’t have liquidity, some policies allow the policyholder to convert the policy to a permanent life insurance policy with a cash value. An insurance agent can help determine if this is an option for a particular term life insurance policy.
The Benefits of Having a Life Insurance Policy with Liquidity
The main benefit of having liquidity in a life insurance policy is that it provides the policyholder with options. If the policyholder needs cash, they can withdraw it from the policy without surrendering the policy or taking out a loan.
Other benefits include;
1. Tax-Advantaged Cash Value
The cash value in a life insurance policy grows tax-deferred. Essentially, the policyholder doesn’t have to pay taxes on the growth, not even when they withdraw the money. Moreover, when they take a loan from the cash value, they don’t have to pay taxes on the loan amount.
An exception to this rule will be if the loan amount is greater than the cash value. In that case, the policyholder would have to pay taxes on the difference between the two amounts.
2. Access to Immediate Cash
Life insurance policies with liquidity can provide much-needed financial assistance during difficult times. For example, if the policyholder loses their job or becomes disabled, they can use the cash value in their policy to help pay bills and expenses.
3. Potential for Dividends
Whole life insurance policies may be eligible for dividends depending on the insurance company. Dividends are not guaranteed, but they are typically a percentage of the premium if the insurance company pays them.
Policyholders can use the dividends to pay for future premiums, increase the death benefit, or cash them out.
4. The Ability to Pass on the Policy to a Beneficiary
The death of a policyholder warrants the paying out of the death benefit to the beneficiary. The payment will include the cash value if the policyholder has not cashed it out or taken a loan against it.
The Disadvantages of Life Insurance as a Liquid Asset
Financial advisers will advise against using life insurance as an investment tool because it is a slow way to grow wealth.
Other disadvantages include;
1. High Fees
Whole life insurance policies and some universal life insurance policies come with high fees. The insurance company typically charges the fees to cover the costs of the policy, such as administration and commissions.
2. Market Volatility
The cash value in a life insurance policy is subject to market volatility. The value can go up or down, depending on the performance of the investments that make up the policy. Ensuring an adequate rate of return is essential to maintain the policy’s cash value.
3. Reduced Death Benefit
Policyholders should be careful when taking money out of their life insurance policy to reduce the death benefit. If the policyholder dies while there is an outstanding loan, the beneficiary may only receive the value of the policy minus the amount of the loan.
How to Get the Most Out of a Liquid Life Insurance Policy
If you’ve read Nelson Nash’s book, “Becoming Your Own Banker” you may be familiar with the concept of Infinite Banking. The idea is to use a whole life insurance policy with liquidity to create your banking system.
Infinite banking is a way of using your whole life insurance policy as a banking system. You can take a loan against the policy’s cash value and use the value of the whole life policy as collateral.
Policyholders can use the loan to pay for regular expenses, such as rent, utilities, and car payments. Remember that the policy is also eligible for dividends, so the policyholder can potentially increase their cash flow over time.
All a policyholder has to do is to make sure they have an adequate amount of coverage. A call to their insurance agent requesting a loan on their policy will give them access to the cash they need when they need it.
Benefits of infinite banking include;
- You’re the banker: As the policyholder, you control the loan. You can take as much money out as you need, and there are no restrictions on spending the money.
- No credit checks: Since you’re borrowing from yourself, there is no need for a credit check.
- No loan origination fees: There are no fees to take out a loan against your life insurance policy.
- Tax-free loans: The money you borrow from your life insurance policy is tax-free.
- Flexible repayment options: You can repay the loan at any time, and there are no prepayment penalties.
- Use the death benefit: If you don’t repay the loan, the insurer will use the death benefit to pay off the loan balance.
- Increased cash flow: As the policyholder, you can increase your cash flow by taking advantage of the policy’s dividends.
For infinite banking to work for you, consider overfunding a high cash value whole life insurance policy. You can accumulate the tax-deferred cash value and use it as a source of collateral for low-cost loans. Use the tax-free low-interest loans to pay off high-interest debt, fund a college education, or purchase a home.
Remember, the key to successful infinite banking is to have adequate coverage. Over time, the discipline to duplicate the process creates an ever-growing and permanent banking system.
Before investing, policyholders should be aware of the fees associated with whole life insurance policies. They should also understand that the cash value is subject to market volatility and could lose value if the investments in the policy perform poorly.
Life Insurance as an Asset in Divorce
Divorce is a complicated process, and life insurance can complicate it further. Generally, term life insurance policies are not considered marital property because death benefits aren’t accessible during the policy term.
However, policies that have cash value are subject to equitable distribution in a divorce because the law considers them part of the policyholder’s net worth.
The liquid nature of cash value makes life insurance policies attractive assets for divorcing couples. As such, policyholders must account for cash value, particularly if they hold whole life and universal life policies.
The court will order the policyholder to give their spouse a percentage of the cash value. This percentage can be in the form of a one-time payment or payments over time.
What Does Liquidity Refer to in a Life Insurance Policy? (FAQs)
Answer: Liquidity is how an asset can turn into cash quickly and without penalty. In the context of life insurance, liquidity refers to the ease with which a policyholder can access their policy’s cash value. Most life insurance policies have some form of liquidity, but whole life and universal life policies have the most.
Answer: The main benefit of liquidity in life insurance is accessing cash quickly and without penalty. Other benefits such as tax-free loans, increased cash flow, and flexible repayment options are also attractive. The key is to have a policy that offers these benefits and use them wisely.
Answer: Market volatility is the main risk of having liquidity in a life insurance policy. Policyholders must be aware that the cash value is subject to the same market fluctuations as any other investment. Another risk is that the policyholder may not be able to repay the loan, in which case the insurer can use the death benefit to pay off the loan balance.
Answer: The best way to use liquidity in a life insurance policy is to consider infinite banking. Infinite banking is a strategy where policyholders use their policy’s cash value as a source of collateral for low-cost loans. The tax-free nature of the loans can help policyholders pay off high-interest debt, fund a college education, or purchase a home.
Conclusion
Liquidity is a crucial consideration for life insurance policyholders. It refers to how a policyholder can easily access their policy’s cash value. Whole life and guaranteed universal life policies have the most liquidity, but all policies with cash value have some degree of liquidity.
Policyholders should also be aware of the risks associated with liquidity, such as market volatility. However, with the right policy and planning, liquidity can provide a host of benefits, including tax-free loans and increased cash flow through infinite banking.
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