When it comes to life insurance, there are two basic categories: term life and permanent life. A term life policy is meant to protect a wage earner's family, usually while they are working. If the wage earner passes away, the policy pays a lump sum, a death benefit, to those the policyholder has designated the beneficiaries. Term life policies run for a designated time, though they can be renewed.

Permanent life insurance, also known as cash-value life insurance, isn’t designed to expire within a normal lifespan. Some do routinely terminate when the insured turns 100 years old. Unlike term, permanent life insurance offers both a death and a savings benefit, the latter essentially funded by a policyholder's premiums. Permanent life policies are more expensive than term life because of this cash value portion. There are two types of permanent life insurance—whole and universal life. Of the two, universal offers more investment opportunities that could become a source of savings income, especially after retirement.

If you’re going to view an insurance policy as an income vehicle during retirement, you need to consider the value of that policy when it comes time for it to begin paying you.

Understanding the Two Types of Permanent Life

Whole life insurance offers a consistent premium and a guaranteed cash value accumulation. In return, the premiums are likely to be much higher than they are for term insurance, But the payout is assured. The only risks: that you end up paying more in fees than your return is worth or that the company goes bankrupt.

Universal life offers more flexibility in premium costs, death benefits, and savings because the policies allow policyholders to take advantage of a strong stock market. Universal life policies were very popular as a retirement income vehicle when they were first introduced in the 1980s and 1990s. But a long decline in interest rates pushed monthly insurance premiums much higher, greatly devaluing the cash value of the universal policies bought during that time.

The Reality of Universal Life Investment Earnings

When universal life insurance policies were first introduced, the policies were written assuming rates of return from 11% to 15%. Those policies didn't take into account that as the 20th century ended, interest rates would drop into the single digits, undermining the growth of a policy's cash value. Policyholders found themselves forced to pay premiums entirely out of pocket. If they couldn't afford to pay, their policies became worthless. Once that happened, they faced a large tax bill on any sums they'd withdrawn over the years—undermining a key selling point for these policies.

But what makes universal life so appealing as an alternative to whole life is its flexibility in allowing a policy owner to shift funds between the policy's insurance and savings components. Some policies also allow you to choose how the funds in the savings component will be allocated—similar to how you might choose among different mutual funds for your 401(k) plan

Loans and Withdrawals

As the cash value of universal life insurance plans accumulates, policyholders can borrow against it. In fact, borrowing is the most tax-advantaged way to use these funds. “Life insurance cash values can be accessed during the policy owner’s lifetime through two ways—loans and withdrawals," says Jason Silverberg, an author and certified financial planner at Financial Advantage Associates in Rockville, Maryland. "You can access your basis (what you contributed to the policy), without any tax implications." That is, the funds that are withdrawn from the account usually aren't subject to income tax—unlike traditional IRA and 401(k) plan distributions

"The gains, however, are taxed at ordinary income rates, unless you take them out as a loan," Silverberg cautions. In other words, you technically don't withdraw funds from the insurance policy; you borrow against it. This is not unlike taking out a home-equity loan against the accrued value of your house. These life insurance policy loans are not subject to income tax. While you do pay interest on them, you can use the cash-value account funds to cover the interest payments, too.

What Happens When You Retire

Another key benefit, in addition to the life insurance component, is that you can tap into your universal life policy for income after you've retired. The cash-value account within an insurance policy accumulates tax-free. “Some people use the cash value in their life insurance policy to bridge the gap from [the year of their] retirement to age 70 when they can receive the highest Social Security benefit," says David Wilken, former president of Individual Life Sales for Voya Financial. Others allow their policy to mature and cash out later to receive the maximum benefit.

"In general, the more time you allow your cash-value life insurance policy to grow, the better," adds Wilken. "A good rule of thumb is to plan to wait at least 15 years [after you purchase a policy] before you begin taking distributions.”

The Risk of Lapsed Insurance

To take distributions, of course, your insurance policy has to have a cash value. That's never a problem with whole life, but universal life policies are designed differently. Earnings on the cash value are an important component in maintaining the policy—not just the premiums you pay. Often, with universal life policies, the size of the premium varies based on how the investment portion of the policy is performing. In other words, the cash value of the policy isn't just your cash cow; it's there to help pay for the insurance, supplementing or even covering your premiums outright. 

Earnings on cash value are especially important during periods when the policyholder takes out a loan against the policy's cash value. “If you take out too much money and the cost of the policy exceeds the cash value," Wilken says, "it's similar to being underwater on your home." If your insurance policy lapses, not only would you lose your death benefit; all the funds you borrowed or withdrew from the policy would be considered taxable income.   

Deciding What’s Safe to Withdraw

How do you know how much you can safely withdraw before or after retirement? When you buy one of these policies, the terms will be laid out in what the insurance industry calls an illustration. This is a document that highlights the assumptions made to compute your expected cash value, monthly interest rate, and other key components of your policy.

Unrealistically optimistic illustrations were what left so many early holders of universal life policies underwater, often just when they were counting on their holdings to help them in retirement.

In an attempt to ensure more realistic illustrations, the National Association of Insurance Commissioners adopted a new actuarial guideline—AG 49—in 2015 to provide insurance carriers a more uniform method for calculating maximum illustrated rates on equity-indexed universal life insurance (IUL) products. That said, as of 2019, insurance regulators are questioning how accurate and effective those guidelines are.

The Bottom Line

There are pros and cons to every life insurance plan. The best way to determine which is best for you is by defining your goals. If your primary goal is to make sure your loved ones are taken care of after you're gone, term life might be the most cost-effective option. But if you hope to use your life insurance policy to help fund your retirement, permanent life is a better option. Whether you should get whole life or universal life depends in large part on your financial situation and your risk tolerance. In any event, if your life insurance policy was written years ago and you haven’t had a comprehensive review of it lately, it might be time to visit your insurance agent.