Is it better to secure a life insurance policy that you can pay off in 10 years, or stretch out premiums over time until you are 100 years old? How about in between — maybe 15 years, or age 65? And should those payments be made once a year or on a monthly basis?
Obviously, the answer depends on individual circumstances and goals. What might be right for one person may be totally inappropriate for another. That’s why understanding the options and implications of premium payment offerings is important when considering a life insurance policy.
This is especially true for permanent life insurance which, unlike term insurance, builds cash value over time in addition to providing a death benefit. That feature can have an important bearing on the premium payment choice. (Related: Permanent and term life insurance differences)
“We tend to see 10-year pay policies most appealing for people who hit their peak earnings early on,” said Doug Collins, financial planning director at Fortis Lux Financial in New York. “A good example is a trader on Wall Street who may want to retire or semi-retire in 10-15 years, but also might not have long-term job security, so is trying to condense a lifetime of premiums into a shorter window.”
Of course, the actual price of a life insurance policy will depend on the amount of coverage you want, your health, and other risk factors. (Life insurance calculator)
Generally, when thinking about premium options, you should consider:
Additionally, the type of permanent insurance involved can also be a factor amid these considerations. Universal and variable universal life insurance policies can have flexible premium payment requirements. Whole life insurance generally provides for fixed, or “level,” guaranteed premiums payable over time.
Whole life insurance policies can come with a variety of premium payment choices. These can involve how many annual premium payments need to be made to secure the overall death benefit, as well as the timing and frequency of the premium payments themselves.
For instance, one type of policy may require only 10 years of premiums to be fully paid up. Depending on the size of the death benefit, the so-called face amount, those annual premium payments could be quite substantial. Of course, each annual premium may be divided up and paid on a semi-annual, quarterly, or even monthly basis. Such payment choices usually reflect an additional charge.
At the other end of the spectrum might be a whole life insurance policy that requires premiums up to a certain age, such as age 65 or 100, which are most common. If that date is far off, the annual premiums could be relatively small. And, if the policyowner chooses to divvy up the overall annual premium due into, say, 12 monthly payments, the impact on one’s cash flow could be smaller still.
Deciding, then, between these two extremes — and all the choices in between — becomes a question of what can you afford overall on an annual basis as well as what your month-to-month budget can handle in terms of payments to meet that obligation. (Related: Short vs. long premium whole life policies: The difference)
For instance, someone who already has a lot of savings built up or gets a sizable yearly bonus may be able to handle a large yearly payment for a 10 premium-payment whole life insurance policy. Another well-off person may be able to handle the yearly cost, but opt to pay off the yearly premium in four installments for budgetary reasons.
However, those with a tighter budget may prefer a whole life insurance policy that extends premium payments over decades and allows for the annual payments to be on a monthly or quarterly installment schedule.
No matter what premium paying period you choose for your whole life policy, you have the option to elect a Reduced Paid-Up policy at any time. For example, you could choose a pay-to-age-100 policy, but stop paying premiums at age 65 by electing a paid-up policy with a reduced amount of coverage.
Beyond whole life options, someone with income that ebbs and flows with business cycles — a commission-based salesperson or ski resort owner, perhaps — may want a type of universal policy that allows premium payment amounts to decline when times are tough and rise when times are good.
Cash value accumulation
The cash value component of a life insurance policy can be an important feature for some policyowners.
Essentially, it can become a source of funds for emergencies. You can borrow against it for any purpose, be it college tuition, or home improvements, or supplemental retirement income.1 It can also be used to cover a premium payment and keep a policy in force in some instances.
But it takes a number of premium payments to build up the cash value of a life insurance policy and make it sizeable enough to fulfill such functions.
To that end, the number of premium payments required to pay up a life insurance policy becomes important. (Related: Whole life insurance: Balancing protection and accumulation)
Policies with fewer premiums — like the 10-premium whole life insurance policy we referenced above — tend to build cash value more quickly than policies that stretch out payments to age 65 or older.
Building up cash value quickly can be a priority for some people.
Some parents and grandparents look to whole life insurance policies with 10-20 year premium options as a way to purchase life insurance for their children and grandchildren that will be paid up before their early adulthood.
Or those preparing for retirement may want a large cash value in a life insurance policy available to offset market setbacks. (Related: How life insurance can help you in retirement)
And with the flexible premium possibilities of universal life insurance policies, some people pay the maximum premium possible into a policy for the first years of coverage, building up the policy’s cash value. That cash value can then be used to pay premiums if their income shrinks in retirement.
Cash value in a life insurance policy grows on a tax-deferred basis. Additionally, loans against the cash value aren’t taxed up to the level of money paid into the policy (called the cost basis).2 Surrenders, essentially cashing in the policy, are also not taxed up to cost basis.
These incentives also work to make life insurance policies that can be paid up in 10 to 20 years attractive. (Related: How whole life insurance helps diversify your taxes)
There are some limitations, however. If too much is paid in premiums or premium payments amass too quickly, violating a formula set out by the IRS, the life insurance policy will be considered a “modified endowment contract” (MEC) and lose some of its tax advantages. (Related: Mind your ‘MEC’)
“As a general rule of thumb, if you want to maximize the death benefit, the 100-pay policy works best,” said Collins. “But if you are interested in a higher internal rate of return on your cash value, having the policy paid up sooner, such as in a 10-pay policy, accomplishes the goal.”
In the end, the right type of policy will depend on individual circumstances and aims. Many choose to consult a financial professional to sort through the options available before making a choice.
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This article was originally published in February 2020. It has been updated.
1 Borrowing from cash value will reduce the policy's cash value and death benefit, increase the chance the policy will lapse, and may result in a tax liability if the policy terminates before the death of the insured.
2 Distributions under the policy (including cash dividends and partial/full surrenders) are not subject to taxation up to the amount paid into the policy (cost basis). If the policy is a Modified Endowment Contract, policy loans and/or distributions are taxable to the extent of gain and are subject to a 10% tax penalty if the policyowner is under age 59½.