Withdrawing the cash value from your whole life policy may reduce the death benefit. For instance, taking out a policy loan and dying before you’ve repaid the outstanding balance reduces the amount your beneficiaries receive as the insurer deducts the owed amount from the total.
Throughout this article, we’ll discuss the disadvantages and advantages of the various cash value withdrawal methods, as well as how your death benefit may be affected.
The majority of permanent life insurance policies allow the investments within the policy to grow without worrying about annual tax payments. Even though there are limitations and withdrawing can decrease your death benefit, the cash value component lets you protect a large amount of money from accrual taxes inside the policy.
Since life throws curveballs, it might become necessary to access the pot of money during your lifetime. People dip into their policy’s cash value for a variety of reasons, including:
If you aren’t planning to use your cash value, it still offers peace of mind knowing that the money is there should the unforeseen happen.
There are three main advantages to the cash value component of whole life policies, including:
The method you choose to access your life insurance can influence the value of your death benefit. But that doesn’t mean you should never withdraw from the policy — it may well be the right solution for you.
Below you’ll find the four ways you can withdraw your whole life policy’s cash value:
A clause in your whole life insurance policy ensures you can access the accumulated cash value through a policy loan. Your insurance provider offers the loan, and you must pay interest on the loan. However, the cash value continues to grow as it did before.
With that said, the policy loan could affect the death benefit. If you still owe money on the policy loan when you die, your provider deducts the outstanding amount from the death benefit. Therefore, you run the risk of decreasing your beneficiaries’ payout.
Depending on your policy type, you may be able to take a policy withdrawal from your accumulated cash value. As this method reduces the overall cash value, it can impact the pot’s future growth and decrease the death benefit.
To use this method effectively, you need to be aware of the pro-rated policy adjusted cost bases (often abbreviated to ACB). Why? Because if you withdraw an amount that exceeds the ACB, the payout is deemed a taxable disposition. In other words, it becomes taxable income.
Using the cash value portion of your life insurance policy raises some tax problems that you should think about prior to permitting the withdrawal. Canada’s Income Tax Act considers withdrawals from your cash value as taxable dispositions.
As we mentioned, the taxes could be payable on the amount that exceeds the pro-rated adjusted cost basis. Most insurers calculate the ACB like this:
aggregate premiums for the years – the cumulative net cost of pure insurance = ACB
NCPI (net cost of pure insurance) is the amount at risk multiplied by the probability of dying before the year ends. Essentially, it’s the difference between your death benefit and the cash surrender value.
Of course, the likelihood of dying rises each year. So, even if your premiums and the net amount at risk stay the same, the NCPI could still increase because of the increasing probability of your death.
Another way to access the cash value portion of your life insurance is to use it as collateral to get a secured line of credit from a lending institution (not the insurer). Canadian law doesn’t inflict personal or corporate tax on loan advances, which is perhaps the primary advantage of this method.
However, the strategy involves more admin and carries a greater risk than withdrawing from your policy or taking out a policy loan. Plus, you will need to tell the lender about your financial climate and spend the time applying for the loan outside of the insurance agreement.
Throughout the collateral agreement, you remain the owner of the policy. But, you pledge the cash value as collateral — i.e., you risk losing it should you default on your line of credit repayments. With this arrangement, the interest can either be paid per annum or capitalized.
Upon your death, the outstanding loan balance plus interest is given to the line of credit lender from your death benefit. The remaining proceeds go to your beneficiaries. So, utilizing your cash value as collateral potentially lowers the death benefit.
In a pinch, you can choose to surrender the entirety of part of your policy. If you choose to surrender the policy, you’ll no longer be insured afterward. But if you surrender part of it, the value of your policy reduces but you continue having cover.
If you’re unsure about how withdrawing from your cash value may affect your specific death benefit and situation, talk to Sim Gakhar. We can also advise you to make a whole life policy part of a larger financial plan to enhance your wealth further.
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