I'd like to clarify one detail about Whole Life policies and it’s that the death benefit in a Whole Life policy (and ONLY a Whole Life policy) has a cash value component associated with it. In doing so I’m going to squash the common myth a person is stuck paying premiums every year for life or they lose their Whole life policy.
Since what the majority of what people think they know about life insurance is based on someone else’s misunderstanding, let’s start with this critical error in thinking:
99.9% people (including nearly all people licensed to sell life insurance) believe the death benefit is just that… a death benefit that only has value to the beneficiary. People have no idea that the death benefit in a Whole Life policy has additional benefits while you are alive! MAJOR MISUNDERSTANDING.
Let’s take a look at a 5 pay policy design funded for a client from existing banks assets into a Non-MEC IBC Whole Life policy to quickly illustrate the point:
(Note: a 5-pay design should only be used if a person already has existing assets to fund a policy. It is not an ideal long-term funding strategy for IBC because one of the important concepts about IBC is that money needs to reside somewhere. Paying up a policy after 5 years means you will need to find a home for additional dollars elsewhere and you’ll need to open a new policy, if you medically qualify, to fund contribute additional premiums.)
Please first look at the Total Premium column (third from the left).
You will notice that in years 6 and 7 there is premium due in the policy of $26,148 and $25,398 respectively. This is because of the 7 Year Pay Rule which is an IRS test to help determine if a life insurance policy design meets the minimum requirements at policy issue to be classified as Non-MEC (tax-free access to cash values via policy loans) like the illustration above, or as MEC which will be treated as an investment (gains taxed as ordinary income) which we want to avoid.
So to bypass too much premium going into a life insurance too soon, premiums are needed to be spread out for for at least 7 years to support a minimum amount of death benefit and achieve Non-MEC status.
However, if you scan to the Premium Outlay column (fifth from the left), you’ll notice $0 is needed to satisfy the Total Premium owed in both years 6 and 7.
How can the death benefit be used to offset the policyowner paying premium dollars out of pocket?
The answer lies in the true value of the death benefit. You should now notice that the death benefit has decreased in both years 6 and 7 to offset the Total Premium due in the policy.
By offsetting the premium (or reducing the death benefit), the policy owner is able to satisfy the minimum premium required in years 6 and 7 with no money out of pocket (premium outlay).
The Big Takeaway
This is possible because the FUTURE death benefit in a Whole Life policy has a PRESENT cash value component.
The point bears repeating but in a different way: the death benefit is the future value of the present cash value.
In the ledger above, this future death benefit is paying the premium. In year 6 and 7 is an annual reduction in the death benefit to offset the minimum annual premium. Then beginning year 8 (7 Year Pay Rule has ended) the policy owner can make the election for a permanent reduction in the death benefit.
This rarely discussed policy election, known as “RPU” (Reduced Paid-Up), permanently offsets the minimum annual premium needed for the remaining contract years. No more premium due for the life of the contract.
Let’s quickly review the additional benefits of a Whole Life policy death benefit:
- The obvious benefit: tax-free inheritance
- The little known benefit: cash value can be accessed tax-free via policy loans when policies are designed and funded properly
- The not-so-obvious benefit: the death benefit in a Whole Life policy can provide premium payment flexibility to offset premium due either temporarily (one year at a time) or permanently.
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Thank you,
John Montoya
