If You Wonder What ‘Liquidity’ Refers to in Life Insurance: Here’s the Answer with Sample for You!

Your life insurance policy may do more than provide your loved ones with a death benefit. Many people use life insurance as an investment.

It’s especially helpful for those who’ve maxed out any tax-deferred retirement plans and want the tax shelter of investing more money.

But how does liquidity in life insurance work? Check out my guide below.

What is Liquidity in Life Insurance?

Life insurance policies with liquidity have a cash value you can use while you’re alive. The cash value is separate from your death benefit. However, if you use any portion of your cash value and don’t pay it back, it reduces your death benefit.

Life insurance liquidity can help you in a financial emergency or even supplement your retirement. Some people use it as a safeguard should they live longer than expected or have unexpected medical bills.

How Does it Work?

Life insurance liquidity is only available on permanent life insurance policies, such as whole life, universal life, or variable life insurance.

Each policy grows a cash value differently. Whole life policies have a guaranteed return, universal life provides a return based on market rates, and variable life insurance is based on the underlying investments.

The cash value is separate from your death benefit. A portion of each of your premium payments goes toward the cash value. The amount varies based on the cost of your death benefit and administrative costs.

How can you use your Cash Value?

If you’ve accumulated a cash value, you have a couple of ways to use it.

Take out a Loan

You can borrow money from yourself. Yes, you’ll pay interest, but it’s interest you pay yourself.

But how much can you borrow?

Most life insurance companies allow you to borrow up to 90% of the life insurance cash value.

Here’s how it works.

You take out a loan from the life insurance company. They use your cash value as collateral. If you don’t pay it back, they take your cash value. You’ll pay annual interest and can repay the amount in any increments or in any frequency you want.

But there’s one problem.

If you take too long to pay it back, you’ll pay compound interest. Suppose the loan amount exceeds the cash value because of the accumulated interest. In that case, you’ll lose your policy and get hit with a significant tax liability for the capital gains from the money received.

Withdraw the Cash

If you’ve accumulated a large cash value, you may withdraw some of it and leave your policy intact.

It sounds crazy, but it’s possible.

To make it work, only withdraw a small fraction of the money you’ve accumulated. You’ll receive the funds tax-free if the withdrawals don’t exceed the amount you’ve paid in.

In other words, if you take out the cash you earned from the account’s interest or dividends, you’ll pay taxes. Keep it lower than that amount, and you won’t pay taxes.

But, there’s one crucial factor.

If you withdraw the funds rather than borrow them, the insurance company will deplete your death benefit dollar-for-dollar. For example, if you have a $750,000 death benefit and withdraw $100,000 of cash value, you’d reduce your death benefit to $650,000.

What Types of Life insurance Offer Liquidity?

Only permanent life insurance policies offer liquidity.

What’s a permanent policy?

Almost any policy except term life insurance. Permanent life insurance policies last for your entire life. They don’t expire at the end of a term. However, they only stay active if you keep up with your premiums.

Some policies like universal life allow you to use your cash value to cover your premiums when your cash value is high enough. Others require you to pay the premiums in order to keep the death benefit.

The most common life insurance policies that offer liquidity are whole life, universal life, and variable life insurance.

An Example of Liquidity in Life Insurance

Just how does liquidity in life insurance work? Here’s an example.

You take out a whole life insurance policy with a $500,000 death benefit. Your premium is $300 a month, but only $150 covers the death benefit and administrative costs. $150 of your premium goes to your cash value and earns interest.

Since you were 25-years old when you took out the policy, by the age of 45, you have quite a nice nest egg set up. You decide at 45 that you want to withdraw some of the cash to pay for your child’s college education.

You take out a loan on the policy. Your death benefit remains the same. You owe an annual interest rate equal to the interest earned on the policy, but it’s a lot less than what you’d pay in student loans. Plus, you’re paying yourself back; you’re not paying a bank.

Note that:

If you pay the balance back in a reasonable time, nothing changes with your death benefit.

Does Term Life Insurance Have Liquidity?

Term life insurance never has liquidity. You strictly pay premiums to cover your death benefit and the administrative costs. If you’re alive at the end of the term, the policy expires.

Some policies allow you to convert to a whole life policy. In that sense, term life policies could be liquid, but only if you convert. The window of opportunity is short, so act fast if that’s an option you want.

Is Life Insurance a Liquid Asset?

When you think of a liquid asset, you think of a savings or checking account, right?

Life insurance can be a liquid asset too. Here’s why.

You can Make Withdrawals

Once you have a decent balance, you can withdraw from your cash value. You don’t have to give a reason or get approved. Just stay within the limits of what the insurance company allows. Most allow you to use up to 90% of the cash value.

You can Surrender your Policy

If you no longer need the death benefit, you can surrender your life insurance policy. Just beware of the fees insurance companies charge. Don’t expect the full cash balance. If you surrender your policy, you give up the death benefit and walk away with cash.

If you earned any money beyond what you contributed, you’d pay capital gains taxes on the distribution.

You can Sell your Life Insurance Policy

It’s rare, but there is a secondary market for life insurance policies. If you need the cash, you can sell it and receive a payout.

Benefits of Using Life Insurance as a Liquid Asset

Like any investment, there are pros and cons of using life insurance as a liquid asset. Here are the pros:

• It’s a tax-deferred investment
• You don’t pay taxes on any withdrawals if they are less than your contributions
• It can provide peace of mind knowing you have an emergency fund
• You determine how you use the funds

Disadvantages of Using Life Insurance as a Liquid Asset

It’s essential to understand the downsides of using life insurance as a liquid asset too:

• You’ll pay capital gains taxes if your withdrawals exceed your contributions
• You can deplete your death benefit if you withdraw too much
• The premiums are much higher than a term policy

Final Thoughts – Life Insurance Liquidity

Should you use life insurance liquidity as a ‘sure thing’ in your financial toolbox?

No.

But, it can be a nice emergency fund or way to pay for high costs, such as college or retirement supplements, if you’ve maxed out all other tax-deferred investments. If you like permanent life insurance, the cash value can be an excellent benefit. Just prepare yourself for the much higher premiums and ensure you can afford them even as you age.