Life Insurance as an Investment
While life insurance is commonly used as a risk mitigation method to financially protect loved ones, many also use it to enhance their investment plans. Some plans offer a cash value component, which the policyholder can borrow from while they’re still alive. Plus, part of the premiums grow on a tax-deferred basis, making it attractive to some investors.
- Written by Thomas Brock, CFA®, CPA
- Edited By
Lamia Chowdhury is a financial content editor for RetireGuide and has over three years of marketing experience in the finance industry. She has written copy for both digital and print pieces ranging from blogs, radio scripts and search ads to billboards, brochures, mailers and more.Read More
- Reviewed ByEric Estevez
Owner of HLC Insurance Broker, LLC
Eric Estevez is a duly licensed independent insurance broker and a former financial institution auditor with more than a decade of professional experience. He has specialized in federal, state and local compliance for both large and small businesses.Read More
- Published: November 18, 2022
- Updated: January 10, 2023
- 7 min read time
- This page features 3 Cited Research Articles
- Reviewed By
- Fundamentally, life insurance is a risk management tool that provides financial protection to your loved ones in the event of your death.
- Life insurance can be used as an investment tool for those who are looking to build cash value through a permanent policy.
- Many people use permanent life insurance as an investment because a portion of the premiums paid are allowed to grow on a tax-deferred basis.
Investing in Life Insurance
People typically purchase life insurance policies to protect their loved ones financially. Life insurance policies provide a cash payout to named beneficiaries in the event of the policyholder’s death.
For this reason, life insurance is predominantly viewed as a risk mitigation tool. However, given the favorable tax treatment policyholders receive, some use life insurance to facilitate the accumulation of wealth. Savvy individuals commonly use life insurance products to optimize their investment plans.
However, there are some types of life insurance that are better for investment purposes than others.
If budget allows for the proposed insured, a mix of both term and permanent life insurance makes sense in many situations. But of course, there is no “one size fits all” for life insurance.
Common Types of Life Insurance
At the highest level, there are two types of life insurance — term and permanent. Term life insurance is active for a specified period — generally, 10, 20 or 30 years. Permanent life insurance, which takes the form of either whole life, universal life or variable life, is active for the duration of the policyholder’s life.
Term life insurance is usually much cheaper than permanent life insurance, making it an economical option for younger people looking to gain some financial security for their loved ones as they establish themselves financially. Unfortunately, with term insurance, there is no equity associated with the policy.
When the stipulated term ends, the death benefit expires, and the insurance company is no longer obligated to provide you financial protection. All premiums paid over the life of the contract are an expense to you and income to the insurance company.
Conversely, with permanent life insurance, you pay higher premiums, but they are divided into two components. The first covers the cost of the policy’s death benefit. The second is a cash value reserve that belongs to you for as long as you live.
You can allow this money to grow, and it can grow on a tax-deferred basis. The funds can be borrowed against as a loan or it can be permanently withdrawn. Generally, permanent withdrawals of the cash value reserve result in a reduction of the policy’s death benefit, and taxes are levied on any accumulated earnings above the policyholder’s basis.
Subsets of Permanent Life Insurance
There are four different types of permanent life insurance. Comparing life insurance policies can help you determine which one is best for your financial needs.
- Whole life insurance
- These policies have scheduled, consistent premiums and a fixed death benefit. It offers a guaranteed fixed rate of interest determined by the insurance company.
- Universal life insurance
- These policies allow the policyholder to adjust the premium payments and the death benefit at any time by any amount (within limits). Typically, interest is earned based on current money market rates. Some policies offer a guaranteed minimum rate of return.
- Variable universal life insurance
- These policies are a subset of universal life. Like a universal policy, a variable universal policy allows you to adjust your premiums and death benefit. Additionally, it offers a much broader range of investment options than a standard universal life policy. Some policies offer a guaranteed minimum rate of return.
- Variable life insurance
- These policies have scheduled, consistent premiums and a fixed death benefit. Generally, these policies offer the broadest array of investment options in the permanent life space. As a result, they are also subjected to the greatest degree of market volatility. That said, some policies establish minimum and maximum rates of return.
Permanent life insurance policies are a better investment tool than term life, but first, you must determine which features you find most valuable in order to choose the best permanent policy for you.
Optimal Life Insurance Investment Plan
There isn’t a single life insurance investment plan that is optimal for everyone. Each policyholder needs to establish a plan that caters to his or her unique investment objectives and tolerance for risk. That said, there are a few guidelines to consider when comparing plans.
- Whole life insurance is best for individuals that have definitive death benefit needs and do not wish to expose themselves to any investment volatility.
- Universal life insurance is best for individuals who desire flexible death benefits and more return potential on their investments.
- Variable life insurance is best for individuals that have definitive death benefit needs and wish to be able to invest in a wide array of assets.
Remember, these policies are types of permanent life insurance. For individuals that just want to purchase life insurance, without the cash value investment component, term life insurance is the best option.
Pros and Cons of Using Life Insurance as an Investment
Given the tax-advantaged nature of permanent life insurance, many people use these vehicles for more than just financial protection for loved ones — they also use it to accelerate their accumulation of wealth.
Unfortunately, using permanent life insurance to enhance investment performance is not wise for everyone. Many policy structures significantly limit growth potential, which can hinder long-term wealth.
There are also many other pros and cons to consider, including those outlined below.
- Higher contribution limits than other tax-advantaged vehicles
- Tax-deferred growth
- Tax-free withdrawals (up to cost basis)
- Potential for downside protection
- Costly premiums and administrative charges
- Limited investment options
- Relatively low returns
- Cash value reserve does not usually pass to heirs
All things considered, using life insurance as an investment is best for high-income individuals seeking to protect their loved ones while sheltering their income from high tax rates. With life insurance, they can achieve peace of mind and sidestep big tax bills.
However, the average-income investor faces too much opportunity cost by investing in relatively low-yielding life insurance products. They can achieve higher after-tax returns by investing directly in mainstream investments, such as publicly traded stocks, bonds and alternatives.
Other Frequently Asked Questions About Investing via Life Insurance
3 Cited Research Articles
- Corporate Finance Institute. (2021, May 16). Insurance Premium. Retrieved from https://corporatefinanceinstitute.com/resources/wealth-management/insurance-premium/
- Investor.gov. (n.d.). Assessing Your Risk Tolerance. Retrieved from https://www.investor.gov/introduction-investing/getting-started/assessing-your-risk-tolerance
- National Association of Insurance Commissioners (2022, June 23). Life Insurance. Retrieved from https://content.naic.org/cipr-topics/life-insurance