Life insurance policies are excellent tools for securing the financial future of your loved ones by providing a monetary gift in the event of your death.
The benefits are numerous; the death benefit bypasses probate, your heirs don't pay taxes on it, and the full amount is payable as soon as the policy is issued.
What many people don't realize, however, is that some life insurance policies can be leveraged as powerful savings vehicles.
The Cash Value
In order to be used as a savings vehicle, a life insurance policy needs to have a cash value. Most whole and universal life policies have this characteristic, while most term life policies do not.
The policy's cash value, as the name suggests, is the amount of money that you would receive if you surrendered the policy to the insurance company. This amount is equal to the contributions made to the policy, aggregated at the policy's interest rate.
The Interest Rate
In the same manner as bank accounts, life insurance policies have stated interest rates. The interest rate may change from time to time, but insurance policies typically have a minimum guaranteed interest rate, which acts as a floor beneath which your crediting rate will never go.
One of the things that make life insurance policies as savings vehicles compelling is that their interest rates are usually much higher than those offered by banks.
Even "safe" investments such as bonds run the risk of default and of declining value in rising interest rate environments, while higher-yielding assets such as stocks come with market risk.
As an added bonus, mutual insurance companies issue what are known as participating life insurance policies. These products offer another way to see your savings grow, in the form of dividends.
When the insurance company is profitable, they pay earnings to their policyholders, providing growth in addition to interest earned.
A life insurance policy allows you to enjoy higher returns than a bank can offer without having to worry about most of the risks associated with other investments.
Every life insurance policy has a minimum premium that must be paid periodically in order to keep the policy's coverage active.
In addition to the minimum premium, however, policy owners can contribute additional amounts to the policy – using the policy much like a savings account. All contributions will earn interest on a tax-deferred basis. This can make a life insurance policy a very effective tax shelter for savings.
Policy owners need to be aware of contribution limits, too. Life insurance policies which are overfunded become permanently designated as modified endowment contracts, or MECs.
Once a policy becomes a MEC, it becomes subject to adverse tax consequences such as taxes on policy loans.
Once the cash value grows to a certain level, you can put your savings to work by borrowing against them. Taking a loan from an insurance company is nothing like taking a loan from a bank, though.
Instead of having to submit income and credit verification, as well as having the lender take a lien on your property, you simply complete a loan request and wait a few days for the insurance company to send you the money.
The insurance company doesn't care what you use the money for, and you even get to decide on the timeframe in which you will repay the loan.
Any loan amount left unpaid at the time of your death will simply be deducted from the policy's death benefit. That makes for stress-free borrowing.
Peace of Mind
Traditional banks operate under a system known as fractional reserve banking. This allows them to keep only a fraction of deposits on hand – in some cases only 10% – while loaning out the remaining deposits or using them to make risky investments.
Life insurance companies are required by laws and regulations to act more responsibly with their premiums.
Insurers must keep very large reserves on hand, and the money that they do lend or invest must be used for very conservative purposes such as commercial mortgages and high-quality bonds. As a result, life insurance company failures are incredibly rare.
In modern times, the United States has not had a crisis that kept savers from accessing their money, but when the next financial crisis hits, who would you rather trust with your money: a bank or an insurance company?
Put simply, insurance companies are much more financially strong than banks.Have any thoughts or questions about what was covered in this post? Feel free to comment them down below.