Using Life Insurance as an Investment: What to Know

This discussion of investing is for general education only. It isn't personalized investment advice, and it isn't a recommendation to buy or sell any particular stock, security, or other investment.

Life insurance exists mainly to leave money for the people you love after you die. But that's not the only reason people buy it. A recent survey found that 23% of Americans who buy life insurance do so partly to build cash value and save toward retirement.

You can use certain life insurance policies to build savings over time, but this isn't a typical investment, and it isn't the right fit for everyone. Here's how cash value works and how to decide whether it makes sense for you.

» more: Cash value life insurance: Is it right for you?

A quick note: Life insurance is meant first as a safety net for the people you leave behind. Before you think about its investment features, consider whether you need life insurance to replace your income if something happens to you.

How life insurance works as an investment

Life insurance comes in two basic forms: term and permanent. Both pay a death benefit, but only permanent coverage can build cash value over time.

That's because permanent policies, like whole life insurance, set aside part of your premium in a reserve called the "cash value." This money grows tax-deferred, and you can withdraw or borrow against it while you're alive to cover expenses.

Term life insurance has no cash value. It covers you for a set period, such as 20 or 30 years, and costs less than permanent coverage. You may come across the phrase "buy term and invest the rest" while shopping for a policy. This approach means choosing a term policy and putting whatever you would have spent on permanent coverage into a separate investment, such as stocks. Talk with a fee-only financial advisor to see whether this strategy fits your situation.

Types of life insurance policies that build cash value

How quickly your cash value grows depends on the type of policy you hold, how long you've had it, how much you pay in, and your policy's specific terms.

Why life insurance isn't always the right investment

Depending on your coverage and your goals, life insurance might not be the most efficient way to grow your money. Weigh these three points before treating a policy as an investment.

1. If you don't need the coverage, other investments may serve you better. Life insurance's main job is providing money for your beneficiaries. If you don't actually need that protection, it's worth exploring other investment options first.
2. The cash value doesn't pass to your heirs. It's usually separate from the death benefit — something you can tap into while you're alive, not an addition to the payout. And if you withdraw funds or take a loan against it without repaying, the death benefit shrinks by that amount or more.
3. Cost and eligibility often hinge on your age and health. Getting coverage may require a medical exam, a step you won't face with other investment accounts like a 401(k) or IRA.

» more: Is whole life insurance a good investment?

Pros and cons of treating life insurance as an investment

Pros

• Can supplement other sources of retirement income.
• May let you borrow against the cash value.

Cons

• Carries a greater risk of the policy lapsing.
• Often returns less than other investments.

How to grow the cash value faster

Some insurers let you control the pace at which cash value builds. For instance, you might pay off all the premiums on a whole life policy within the first 10 years, or even in a single lump sum, which speeds up growth. Just know that compressing payments into a shorter period raises each individual premium compared with spreading them out.

Did you know... Overfunding a life insurance policy can lead the IRS to reclassify it as a "modified endowment contract." If that happens, early withdrawals from the cash value may trigger extra taxes and penalties.

You may also build cash value through dividends if you choose a mutual life insurance company — one owned by its policyholders. These companies often pay annual dividends to whole life policyholders, which can go toward paid-up additions, or PUAs: small increments of permanent coverage bought with the dividend money that add to the policy's overall value.

Using life insurance as a retirement supplement

Buy a permanent policy while you're young, and the cash value can grow substantially by the time you retire. Withdrawing from it lowers the death benefit, but by then you may not need as much coverage and might prefer to draw on the cash value instead. That money can go toward a wide range of expenses.

A quick note: A cash value alone probably won't cover your whole retirement. Talk with a fee-only financial advisor about building a retirement plan suited to you.

Flexible withdrawals

You can use the cash value for any purpose and withdraw it whenever you like. That's not always true of other retirement accounts, like a traditional IRA, which requires you to start taking minimum distributions in your early 70s. Pulling money from an IRA or 401(k) too early can trigger a tax penalty. Life insurance cash value doesn't carry the same restrictions.

Tax-free withdrawals

You can withdraw up to the policy basis — the total you've paid in premiums — without owing income tax. If you withdraw more than that, though, you may owe tax on the gains.

Tax-free loans against cash value

If you want more than the policy basis without triggering tax on the gains, you can take out a loan instead. There's no qualifying required to borrow against the cash value — it's yours to draw on whenever you choose.

These loans aren't taxed as income, but they do accrue interest, which can build up over time. If the loan balance grows past the total cash value, the policy can lapse. To avoid that, it helps to at least cover the annual interest so the loan doesn't keep growing.

You're not required to repay the loan. But if you die before it's repaid, the remaining balance is typically subtracted from the death benefit, leaving your beneficiaries with a smaller payout.

Other reasons people buy life insurance

Building savings is just one of many reasons people buy coverage. Here are some other common ones.

• Using life insurance to replace your income
• Using burial insurance to cover final expenses
• Buying life insurance to pay off debt
• Using life insurance to leave an inheritance

Common questions

Can I use life insurance to build wealth?

Whole life insurance can be a way to add modest cash value once you've maxed out other tax-advantaged accounts, or as part of a diversified approach. On its own, though, the cash value in a permanent or whole life policy usually isn't enough to replace your income or build substantial wealth.

Which type of life insurance works best as an investment?

Permanent policies that build cash value are generally what people mean when they talk about life insurance as an investment. Which type suits you best depends on your risk tolerance and what you're trying to accomplish.

When is the best time to buy life insurance for investment purposes?

Usually when you're young and healthy. Rates tend to be lower across all types of life insurance for younger applicants, and insurers offer better terms to people they consider lower risk.

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Specific tax and legal treatment of life insurance cash value can vary based on your state and your individual policy, so check the details with your insurer or a qualified advisor before making decisions.