Single Premium Life Insurance
A single premium policy, like all permanent policies, has two components.
The only difference is that regular policies allow you to pay the premium on a monthly, quarterly, or yearly basis – depending on your convenience.
When it comes to single premium life insurance, you generally have three options to choose from – whole life, variable, and universal life insurance.
If you are risk-averse by nature, this might be the best choice for you, since the policy is guaranteed to build cash value at a predetermined rate, regardless of market conditions.
The unique selling point of a variable life insurance policy is that you get to decide where your premium payments are invested.
Depending on your preference, you can choose to invest in a fixed account (which grows at a fixed rate) or a bond account, stock account, index account, or a money market account, all of which grow at a variable rate, depending on how the market performs.
The upside of a variable life insurance policy is that it can accumulate cash value rapidly under favorable market conditions. The downside is that it can also lose cash value when the market goes down. Moreover, the management fees associated with the investment accounts can be quite hefty in many cases.
The downside is that the policy tends to build cash value at a slower rate compared to a whole life or variable life policy, as the premiums are lower, which in turn means that the amount allocated towards the cash value account is also lower.
As is the case with all other types of life insurance, single premium has its advantages and disadvantages. Let us take a look at them now.
A single payment policy, true to its name, requires you to pay only once. The lump-sum payment you make fully funds the policy, which provides you with the coverage you need for the rest of your life – without requiring any additional charges or payments.
A regular permanent policy, in contrast, requires you to make monthly or yearly payments for the rest of your life.
You are covered only as long as the premiums are paid on time. If you stop paying the premiums for any reason – job loss, health problems, legal trouble, and so on – your policy could lapse.
Even though it requires you to pay a substantial amount of money upfront, a single premium policy is cheaper than a regular policy in most cases.
If you are a 45-year old non-smoker who does not have any pre-existing conditions, a $500,000 single premium universal life policy is likely to cost you around $75,000.
A regular universal life policy, on the other hand, is likely to cost you around $3,350 per year. Now, assuming you live until the age of 80, you have to pay a total of $117,250 ($3,350 x 35) until your death.
In the example given above, you stand to save $42,250 ($117,250 – $75,000) by buying a single premium policy instead of a regular policy.
Single premium policies, like all permanent life policies, allow you to access the cash value – in the form of a withdrawal or a loan – as and when you need it. You should, at the same time, remember that if the loan amount is not paid back, it will get deducted from your death benefit.
Apart from this, most single premium policies also have provisions for funding your long-term care and terminal illness treatment expenses.
If you become terminally ill or if you need long-term care as a result of an illness or disability, you can receive a portion of the death benefit amount – either as a lump sum or as a series of payments.
This is, without a doubt, the biggest advantage of buying a single premium policy. With a regular permanent policy, the cash value growth rate is gradual. Only a portion of your premium payments is allocated to the cash value component.
With a single premium plan, the cash value growth rate is much higher, as a large amount is allocated to the cash value component right at the start of the policy’s term.
For instance, let us assume that you pay $5,000 per year for a whole life policy. If 60% of your premium is allocated to the policy’s cash value and if the interest rate set by your insurer is 3.5%, the cash value of your policy will grow by $105 every year.
Now, let us assume you buy a single premium plan for $50,000. If 60% of your premium is allocated to the cash value and if the interest rate set by the insurer is 3.5%, the cash value of your policy will grow by $1,050 every year.
This is one of the reasons why people who are in need of a reliable source of income in their post-retirement life tend to buy single premium policies.
If you buy a policy at the age of 40 and allow it to build cash value without making any withdrawals or taking any loans, you will have access to a substantial amount of money during your post-retirement years.
The potential for accelerated growth makes single premium life insurance an attractive choice for people who want to leave a tax-free legacy for their family.
If you buy a single premium policy at the age of 50 and allow it to accumulate cash value for the rest of your life, you can leave behind a substantial amount of money for your grandchildren.
The death benefit amount that your beneficiaries receive is not taxable. So, your grandchildren can use it to fund their higher education, to start a business, or any other purpose.
The cost of a single premium plan might be prohibitively expensive for many people – especially for those from low and middle income households. It is not cheap life insurance.
For instance, if you are a 40-year old man who does not smoke and does not have any pre-existing conditions, a $100,000 single premium policy is likely to cost you around $16,000.
Needless to say, not many people can afford to pay that kind of money for a policy, especially when you consider the fact that nearly 60% of the people in the country have less than $1,000 in savings.
Even if you happen to have a few thousand saved up, you might not be able to buy the amount of life insurance coverage that you need, especially if you have financial obligations and family members who are dependent on your income.
For example, a $250,000 guaranteed universal life policy is likely to cost you $37,000 – assuming you are healthy enough to qualify for the ‘preferred best’ rate. If you have pre-existing conditions, the policy might cost you even more.
This is one of the reasons why many people are hesitant to buy a single premium policy, even if it is cheaper than a regular policy in the long term.
One of the biggest downsides of a single premium policy is that it is technically not a life insurance policy at all. It is what the IRS calls a modified endowment contract (MEC).
A policy is considered a MEC if it does not pass the 7-pay test. Each policy has a MEC limit – the maximum amount of premium that you can pay in the first seven years.
If the amount of premium you pay in the first seven years exceeds the limit, your policy automatically becomes a MEC.
Let us say you buy a universal life policy, whose MEC limit is set at $5,000 per year. Based on the 7-pay formula, the maximum amount of premium you are allowed to pay in the first seven years is $35,000 ($5,000 x 7). If you pay more than that, it becomes a MEC.
With a single premium policy, you are required to make a lump-sum payment – which is sufficient to fund the policy for the rest of your life – upfront. As a result, it fails the 7-pay test right at the outset, which makes it a MEC.
Now, you might be wondering as to how a MEC differs from a life insurance policy and why it matters. It matters because of the way a MEC is taxed.
One of the biggest benefits of a permanent policy is the tax benefits it offers. The cash value of your policy increases on a tax-deferred basis. You are only required to pay taxes when you withdraw the money, that too if the amount withdrawn is larger than the amount of premiums paid into the policy.
The dividends paid by the insurer – if any – are not taxed, as they generally come under the ‘return of premium’ category. The death benefit amount, needless to say, is not taxed either.
On the other hand, if your life insurance policy is classified as a MEC, you lose some of the tax benefits mentioned above. For example, if you make a withdrawal or get a loan against your policy’s cash value before you reach the age of 59½, you are required to pay a 10% penalty. In addition to that, you have to pay taxes on the amount you withdraw or borrow.
Let us assume that you are 55 years of age and want to withdraw a sum of $8,000 from your policy’s cash value.
In this case, you have to pay a 10% penalty, which is $800, and pay taxes on the remaining $7,200. Assuming you fall into the 22% tax bracket, you have to pay $1,584 in taxes. As a result, the amount of money you will actually receive is $5,616.
You can determine if you should buy a single premium policy or not by asking yourself the following questions.
You should calculate the amount of life insurance coverage you need, get personalized quotes from various insurance providers, and then decide if you can afford to buy a single premium policy.
If you need any help in calculating the amount of coverage you need and in getting personalized quotes from insurers, the experts at noexam.com will be happy to help you.
Based on your financial situation, do you think you can let the policy uninterruptedly build cash value until you reach the age of 59½?
As mentioned above, any amount of money you withdraw or borrow from the cash value of your policy – before you reach the age of 59 ½ – will incur penalties and taxes. So, unless it is an emergency, you should avoid dipping into your policy’s cash value before you reach the stipulated age.
Once you turn 59 ½, you can withdraw or borrow against your policy’s cash value without having to pay any penalties. Moreover, if you are planning to leave a legacy for your grandchildren, you should avoid accessing the cash value for your own needs.
If you borrow against the cash value and pass away before paying it back, the amount you were supposed to repay (principal, interest payments, and penalties, if applicable) will be deducted from your policy’s death benefit, which in turn will reduce the amount of money your beneficiaries will receive.