What Does Liquidity Refer to in a Life Insurance Policy?
- Find out what liquidity refers to in a life insurance policy and how it affects your access to cash value. Learn what types of insurance have high liquidity.
Carefully weighing your options for obtaining money is important when you need cash in an emergency or to pay a major expense like higher education or long-term care. Knowing what liquidity refers to in a life insurance policy and what policies are liquid assets can help you make informed financial decisions.
What Does Liquidity Refer to in a Life Insurance Policy?
Some life insurance has a cash value in addition to a promised death benefit. With this type of insurance, a portion of your monthly payment is set aside and either put into a cash account or invested. Liquidity refers to how readily available the cash value of an insurance policy is. Insurance policies with high liquidity give you quicker, easier access to cash.
What Is the Term Liquidity?
In general, liquidity describes any type of asset that you can exchange for cash with relative ease. For an asset to be liquid, the money doesn't just need to be available. You also must be able to withdraw it without losing a significant amount of money.
Examples of liquid assets include:
- Checking and savings accounts
- Mutual funds
Assets that have some liquidity include:
- High-performing, in-demand stocks can usually be sold quickly and without a significant amount of loss. However, more volatile stocks have less liquidity because you may take a loss if you sell.
- Certificates of deposit (CDs). You can often close a CD early, but banks charge a fee that greatly lowers the value of the asset.
- Retirement accounts. Until you reach age 59.5 years, you may pay significant penalties for taking money out of a retirement account early.
Assets that have no liquidity include:
- Fine art
Is High Liquidity Good?
Owning at least one asset with high liquidity is important to your financial health. Highly liquid assets ensure that you have access to money whenever you need it. However, you don't need to keep all your money in highly liquid assets. Financial advisors typically recommend a balanced approach to investing that mixes asset types so that you can maximize interest earned and always have access to cash.
What Types of Life Insurance Have the Most Liquidity?
Whole life and guaranteed universal life insurance generally offer the highest liquidity. With these policies, your cash value is usually kept in an account that pays interest like a savings account and allows for easy withdrawal. Universal and whole life insurance are both permanent policies, but they have some differences.
- Whole life has a guaranteed cash value. With most policies, you pay the same premium every month and the death benefit remains the same unless you make a cash withdrawal.
- Guaranteed universal life also has a guaranteed cash value. This type of insurance gives you the flexibility to increase and decrease the premium payment and the death benefit.
Some types of permanent life insurance are less liquid because they pose a risk for financial loss due to variable interest rates based on the performance of other financial instruments or stock indexes. If the investments used to determine the interest rate decline in value, the balance in the cash account decreases. Should you withdraw the cash at this point, you'd take a loss. Examples of life insurance policies that carry this type of financial risk include:
- Variable life
- Indexed universal life
- Variable universal life
Does Term Life Insurance Have Liquidity?
No, term life insurance doesn't build up a cash value, so it doesn't have any liquidity. Some people prefer to take out term life policies because they usually have lower premiums than permanent insurance. Many term life policies give you the option to convert to permanent insurance like whole or universal life. If you convert the policy, you would begin to accumulate a liquid cash value.
Is Life Insurance a Good Asset?
The main reason to purchase life insurance is to provide money to your beneficiaries when you pass away. However, permanent life insurance gives you an asset as a secondary benefit. Some advantages to using life insurance as an asset include:
- Tax benefits. The cash value of a life insurance policy is typically not subject to taxes as it grows. Proceeds from loans on policies are also tax-free, and the death benefit paid out to your beneficiaries isn't usually taxable. As a result, permanent life insurance is often a good way to pass money onto heirs if you have a large estate that may be subject to inheritance tax.
- Diversifying means spreading your money into a variety of investments. If you pass away during an economic downturn that causes other investments to lose value, your beneficiaries are guaranteed to receive a death benefit from your life insurance.
- Potential for dividends. Some whole life insurance policies pay annual dividends. The IRS generally considers dividend payments to be premium refunds, so you normally don't have to claim them on your income taxes.
Using life insurance as an asset does have some disadvantages that you need to know.
The biggest downside to using life insurance as an asset is that cash value takes time to build up. During the early years of a policy, you may not have enough to cover your expenses. In most cases, cash value doesn't reach a significant level until around the 10th year of a policy.
Single-premium life insurance is an exception to the rule. This type of life insurance requires just one initial payment and accumulates cash value quickly. Generally, you need to invest a minimum of $5,000 to $10,000 to get single-premium life.
Reduction of Death Benefit
Usually, withdrawing cash from your life insurance policy decreases the death benefit that your beneficiaries receive. If you take out a loan against the cash value and don't pay it off in full before you die, the balance owed will also be deducted from the death benefit.
Lower Interest Rates
Interest rates paid on whole and guaranteed universal life are generally lower than what you might receive from other investments. Variable life, indexed universal life and variable universal life usually pay higher interest rates, but they pose a risk for loss and are less liquid.