“You are all set, Mr. Smith, with your variable universal life policy that you will be funding for the next ten years. The cash value should accumulate nicely as long as you, or I, as your agent, remembers to switch the death benefit option from increasing to level in 11 years!”
Does this sound like a recipe for disaster?
In the realm of life insurance, understanding the nuances of a policy is crucial, especially when it comes to leveraging it for cash value accumulation. One aspect that often goes overlooked, but that holds significant importance, is the death benefit switch from an increasing death benefit option during the funding phase to a level death benefit option after funding has been completed.
This mechanism is a pivotal component for policyholders focusing on maximizing their policy's cash value potential. Here, timing is critical, and forgetfulness can be devastating.
Understanding the Death Benefit Switch
To start, let's clarify what a death benefit switch is.
In essence, it's an option in certain life insurance policies, particularly universal life policies, that allows the policyholder to adjust the death benefit amount. This feature is particularly relevant for policies designed for cash value accumulation, where the primary goal is not just the death benefit but also building a tax-advantaged savings component.
While this design is found in general account universal life policies, it is widely applicable in variable universal life and private placement variable universal life policies.
Why the Switch Matters in Cash Value Accumulation
When a life insurance policy is structured with a focus on accumulating cash value, the costs associated with maintaining the death benefit can become a significant drag on that accumulation.
Here’s where the death benefit switch plays a crucial role. By reducing the death benefit, a policyholder can minimize the cost of insurance charges, thereby allowing more of the premium to contribute to the cash value growth.
Timing the Death Benefit Switch
Identifying the right time to make this switch is pivotal. Generally, the optimal time is when the premium funding period has ended, or the cash value has grown sufficiently to support a reduced death benefit without incurring additional out-of-pocket costs. This typically occurs in the later years of the policy when the cash value has had time to accumulate and compound. In addition, life insurance companies often have different approaches to when they will allow a death benefit option switch.
For most policyholders, this switch should be considered when:
The policy’s cash value has grown significantly.
The policyholder does not need a dollar more of death benefit than the U.S. Treasury Department’s definition of life insurance requires for the policy to be consider life insurance.
The policyholder is more focused on the policy as an investment vehicle rather than a source of death benefit protection.
The Consequences of Ignoring the Switch
Failing to adjust the death benefit can lead to several undesirable outcomes.
First, higher costs from paying for unnecessary death benefit can erode the policy's cash value, reducing the efficiency of a policy being utilized for cash value accumulation.
Second, if the cost of maintaining a high death benefit becomes unsustainable, it might lead to a policy lapse, where insurance coverage is loss and taxable gains can be recognized on any loans taken from the policy.
Moreover, not optimizing the death benefit can result in missed opportunities for tax-efficient cash accumulation and wealth transfer via a policy income tax-free death benefit. For individuals using life insurance as part of their retirement planning or estate strategy, this oversight can significantly impact the intended financial outcomes.
In the Words of RuPaul, “Don’t F*ck It Up!”
The death benefit switch is not just a feature of certain life insurance policies but a crucial tool for anyone using their policy for cash value accumulation. Its careful use can significantly enhance the policy's efficiency and align it better with the policyholder’s goal of future income or wealth transfer. Remember, a well-timed and well-planned switch can be the difference between a policy that merely provides life coverage and one that serves as an important component of a broader financial portfolio.
At Life Insurance Strategies Group, we do not sell products. We help our individual and institutional clients make decisions involving complex life insurance transactions.