Sometimes, retirees may find themselves in need of funds to cover unexpected expenses like medical illness, a higher-than-anticipated cost of living, and relocation costs. In these moments, liquidity becomes essential.
What many retirees may not realize is that a life insurance policy can serve as a source of liquidity and much-needed funds. What does liquidity refer to in a life insurance policy? The answer may be simpler than you realize, though there are things you should know if you want to make use of your policy’s liquidity potential.
Before we continue, it’s important to define some basic life insurance policy terms:
- Life Insurance: A policy that pays a death benefit to beneficiaries when the insured passes away.
- Liquidity: The ability to convert an asset into cash quickly and easily.
What is liquidity in life insurance?
Liquidity in life insurance refers to the ability of a policyowner to obtain cash from their active policy, whether by withdrawing cash value, taking a loan, surrendering the policy, or selling it through a life settlement.
Only permanent life insurance policies, such as whole and universal life insurance, have built-in liquidity through their cash value component, which accrues interest over time. This allows policyholders to withdraw funds or sell their policy for cash.
While term life insurance policies don’t have a cash surrender value, they can still offer liquidity under certain circumstances — for example, if the policy is sold to a licensed life settlement provider or converted to a permanent policy that can then be sold.
What types of life insurance policies offer liquidity?
Permanent life insurance policies are the only policies that offer built-in liquidity, which is why they tend to cost 5 to 15 times more than term life insurance policies.
There are three types of permanent life insurance policies and all offer liquidity:
- Variable life: the policyowner chooses funds to invest in; any gains or losses depend on market performance
- Whole life: the policy grows at a rate set by the provider with a guaranteed minimum
- Universal life: interest accrues based on market index performance, with the policy provider setting the policy value’s floor and ceiling
Is life insurance a liquid asset?
Only certain kinds of life insurance policies offer liquidity, and are therefore considered liquid assets that can be easily converted into cash. In addition, once paid out to the policyowner’s beneficiaries, the death benefit is itself considered a liquid asset.
A life insurance policy is considered a liquid asset if it satisfies any one of these three conditions:
- The policy has an accumulated cash value. Funds can be withdrawn in a way similar to a retirement account.
- The policy can be cashed in. If you can’t afford or no longer need your policy, you can find how much it’s worth and sell it via a life settlement.
- The policy is surrendered. Since the surrendered policy gives the policyowner cash, it becomes a liquid asset.
What are the advantages of liquidity in a life insurance policy?
A life insurance policy with a cash value (which means it has liquidity) is great for those who can afford policies with high premiums and want the flexibility to dip into the policy’s cash value fund in the future. There’s no fee or tax penalty for making withdrawals. Taking out a life insurance policy with built-in liquidity gives you an additional tax-deferred investment account, which makes it easier to handle expenses that may arise unexpectedly, such as qualifying conditions from a medical emergency.
Are there disadvantages to liquidity in a life insurance policy?
While liquid life insurance policies offer financial flexibility, they also come with significant drawbacks. It can take over a decade of paying the premiums on your permanent life insurance policy for it to accrue a significant cash value sum. That’s why these policies should be thought of as a high-cost long-term investment. And because it can take many years for the cash value to accrue, permanent life insurance policies aren’t the right solution if you anticipate that you may need a source of short-term funding.
Can you add liquidity to your current life insurance policy?
If you currently possess a term life insurance policy, there’s no cash value component; therefore, you can’t add liquidity. However, your policy may have an option for a term conversion rider, which lets you convert some or all of your term coverage into a permanent policy with liquidity so that you can start to accumulate cash value. It’s important to note: it can take a long time to grow your investment, so this may not be the most ideal way to add liquidity.
Examples of life insurance liquidity
There are several ways to access the liquidity in your life insurance policy, each with its own benefits and considerations.
Policy Loans
A policy loan allows you to borrow money against your policy’s cash value. Since the loan is secured by your own policy, you typically don’t need a credit check or have a fixed repayment schedule. These loans can be a good option for covering unexpected expenses or refinancing debt. However, it’s crucial to manage the loan properly, as unpaid interest can reduce the death benefit and could even cause the policy to lapse if the loan grows too large.
Cash Withdrawals
You can make a cash withdrawal from your policy’s cash value, which gives you access to funds without a repayment requirement or interest. Withdrawals are generally tax-free up to the amount of premiums you have paid. Keep in mind, however, that taking a withdrawal will reduce your policy’s death benefit, which could impact the financial security you intended for your beneficiaries.
Surrendering Your Policy
If you no longer need your life insurance coverage, you can surrender your policy to the insurer in exchange for its cash value. This option gives you access to the accumulated funds, but it permanently terminates your life insurance coverage. Be aware that surrendering a policy may involve surrender charges, which can reduce the final payout you receive.
Questions about life insurance or life settlements?
Taking out a life insurance policy that provides liquidity can be a great way to secure your loved ones’ future while also giving you a valuable source of cash should you need it during your retirement. By understanding how to access your policy’s cash value and weighing the pros and cons, you can make an informed decision that aligns with your financial goals.
If you have more questions about life insurance policies, visit Coventry Direct’s blog. Or, if you want to learn more about how to sell your life insurance policy, get started by clicking here!
*Coventry Direct does not offer tax or legal advice. This material has been prepared for informational purposes only and should not be relied upon for tax or legal advice. Coventry Direct urges you to consult with your own tax or legal advisors before entering into any transaction.
