Table of Contents
Table of Contents
To keep your life insurance protection in place, you must make the scheduled premium payments. If you stop paying the premiums or cancel your policy outright, you can lose or forfeit your coverage.
However, it's important to note that policies with life insurance cash value can include nonforfeiture options. These options let you keep some insurance and financial benefits even after you stop paying. Here's how these options work and when they apply.
What Is Life Insurance Cash Value?
Nonforfeiture options are only available for life insurance with cash value. Cash value is an additional benefit included with some permanent life insurance policies. Permanent policies are those that are designed to last your entire life provided that you keep paying your premiums. Permanent policies do, however, have maturity dates that state when coverage will end.
If your policy offers cash value, part of your monthly insurance premiums can go toward building this reserve. The life insurance company may also invest your cash value balance so it grows over time. You could then take out your cash value while alive through a loan or a withdrawal. Keep in mind that doing so would reduce the death benefit for your beneficiaries if the loan isn't repaid. You could also owe income tax for taking a withdrawal or incur interest when taking a loan.
How Does a Nonforfeiture Clause Work?
A nonforfeiture clause explains what would happen to your life insurance cash value if you stop making premium payments or decide to cancel a policy with cash value. It lays out different options for how you could receive or use the cash value. State governments require insurers to have these contract clauses so that you don't forfeit years' worth of building cash value because you missed one premium payment. (Side note: Life insurance companies generally offer a payment "grace period." It provides a specified period, usually 30 days, to make a payment after the due date and bring the policy back to good standing. Details vary by insurer and policy.)
The clause may require that you own the policy for a minimum amount of time before you can use the options. You might need to own your policy for, say, at least three years before you qualify. If you cancel or stop paying before that time, then you aren't guaranteed to receive the benefits. You can check the specific conditions laid out in your contract to see how your clause would work.
What Types of Policies Include Nonforfeiture Options?
Only permanent policies with life insurance cash value can offer nonforfeiture options. Temporary term policies do not have cash value. Therefore, they do not include these options. If you stop paying for — or cancel — your term policy, you lose your coverage and don't get anything back. This could also be the case for a permanent policy without cash value, such as a guaranteed universal life policy, which might not include a nonforfeiture option.
If your permanent policy does have a nonforfeiture clause, the amount that will be available depends on the type of policy. Whole life insurance typically provides the most nonforfeiture protection. These permanent policies include a set return guaranteed by the insurer. As a result, cash value growth is more predictable. Since the insurer can predict how much your cash value will grow over time guaranteed, they could also guarantee nonforfeiture options after a certain point. For example, if you owned the policy for at least three years.
Other permanent policies, such as universal life and variable life, grow cash value using market interest rates or investments. The cash value return changes each year. With variable life, you could even lose cash value some years if your investments do poorly. Because of this unpredictability, the insurer may offer less nonforfeiture protection. For instance, they might say whether you qualify for nonforfeiture options will depend on your remaining cash value at the time you stop paying or cancel.
What Are Your Nonforfeiture Options?
Your insurance company could offer a number of options. What's available depends on which company you work with, but these are five of the most common possibilities:
1. Cash Surrender
With the cash surrender option, the insurer will send you a lump-sum payment for your cash value balance. By choosing to surrender your policy, you end your life insurance protection.
Variable and universal life insurance policies may deduct a surrender charge. If you surrender the policy within 10-15 years of signing up, the insurer would deduct this fee from your cash value. It's typically a percentage of your balance, like 5%, and decreases over time. Whatever is leftover would then be sent to you after you forfeit the policy. For example, if you had $100,000 in cash value with a 5% surrender charge, you would receive $95,000 for surrendering.
You could owe income tax for choosing this nonforfeiture option. If your cash surrender value is less than or equal to what you paid in premiums, you won't owe taxes. However, if you receive more than you paid in total premiums, you will owe income tax on your gain. Your insurer can tell you if you would owe taxes on the cash surrender.
Note that you will owe your regular income tax rate on any cash value growth. Such growth doesn't qualify for taxation at the lower capital gains rate.
2. Reduced Paid-Up Insurance
If you'd like to keep some life insurance without paying any more premiums, you could elect a reduced paid-up insurance option. This would enable the life insurance company to replace your existing policy for another one with a smaller death benefit. The insurer would tell you how much paid-up insurance you qualify for based on your cash value and past premium payments.
If you switch to this paid-up policy, the insurance company wouldn't charge any more premiums for the rest of your life. For example, the insurer could potentially let you swap your $500,000 policy for one with $150,000 of protection that's fully paid for.
3. Extended Term Insurance
Extended term is another way to keep your coverage without owing any more premium payments. With this option, the insurer would put your cash value toward a temporary term life insurance policy. You would then get term protection for the same size death benefit as your existing coverage.
However, this term policy would have an expiration date, typically within five to 20 years. If you outlive the term, your coverage ends. The insurance company would tell you what length term you could receive based on your cash value balance when you make this decision.
4. Automatic Premium Loan
Your insurer could also let you use the cash value to cover your premiums through an automatic policy loan. Each premium payment will reduce your remaining cash value balance. When you take out such a loan, the insurer will charge interest on your outstanding debt. You would then have the option to pay off the premium loan at any point to return to your previous balance.
If you die while insured before paying off the loan, the insurer will deduct this amount from the death benefit before paying the rest to your beneficiaries. If you use up all the cash value on premiums, the policy will lapse (unless you resume paying premiums again).
5. Annuity Conversion
One other possibility is that your insurer could let you exchange your life insurance policy cash value for an annuity. An annuity is a type of contract that turns your savings into future income. You wouldn't owe any tax for transferring your life insurance cash value into the annuity. The annuity would then continue to grow your balance.
At any point, you can choose to start receiving annuity payments. You could receive payments for a set period of time, such as monthly payments for five years. You could also receive annuity payments guaranteed for the rest of your life. The insurer would tell you how much you could receive for each option.
The downside of switching to an annuity is you lose your life insurance protection. In addition, an annuity wouldn't give you full access to all your cash. The insurer might let you take out some of your balance penalty-free — maybe around 10%. If you try to take out more at one time, they may charge a surrender penalty. You would also owe income tax plus possible a 10% penalty if you are younger than 59 ½ for making lump-sum withdrawals of your cash value gains from an annuity.
What Situations Would Trigger a Nonforfeiture Option?
There are two situations that would trigger a nonforfeiture option. First, you stop paying your premiums. Second, you contact your insurance company to cancel the policy. If you miss a premium payment, your policy will have a one-month grace period. This is required by state law. Your coverage continues as normal during this time except that, If you die during the grace period without paying the past due premium, your beneficiary will receive the death benefit minus the money you owe. As long as you make the missed payment within the grace period, everything remains the same with your policy.
However, if you go longer than a month without paying, then your coverage will lapse. At this point, your insurer will try to contact you to figure out what to do next and ask which of the nonforfeiture options you want to use. If they can't reach you, the insurer would eventually move forward with the default option listed in your contract, typically extended term insurance.
If you contact the insurance company to cancel, it's the same process. The difference is you proactively choose what nonforfeiture option you want when you end your coverage.
Are There Any Exceptions?
For nonforfeiture options to apply, your policy must have a cash value balance. If you've taken out all your cash value already, either through a policy loan or withdrawal, then you no longer have money to pay for these options. You wouldn't receive any further benefits after canceling your policy or missing premium payments.
The same is true if you still have cash value, but it's less than the surrender charge. You need a positive balance after fees to pay for the options. Also, if your contract says it must last a minimum number of years to guarantee nonforfeiture options and it's been less than that time, you might not qualify.
What Are the Potential Pros & Cons of Nonforfeiture Options?
Pros
- It protects your cash value. Say you built up your cash value through years of dedicated premium payments. A nonforfeiture clause helps make sure your money is protected, so it's not lost to the insurer even if you can no longer make the premium payments.
- It puts your cash value toward another financial goal. Nonforfeiture options can provide money for your other financial goals through a lump-sum cash payment or by setting up an annuity for future income.
- You can continue your life insurance coverage. Nonforfeiture options also give you several ways to extend your life insurance: through a paid-up smaller permanent policy, an extended temporary term policy or by covering the premiums on your existing policy with a loan.
Cons
- It reduces your insurance coverage. If you use a nonforfeiture option to get a policy that doesn't charge premiums, the benefits will likely be reduced in some way. Either you switch for another permanent policy with a smaller death benefit, or you get a term policy for the same death benefit, but it will expire if you outlive the term.
- It could lead to extra taxes. If you elect to surrender your policy cash value for a lump-sum payment, you'll owe income tax for any amount beyond what you paid in premiums.
- It's not available on all policies. Only permanent policies with cash value include nonforfeiture options.
How Should You Decide Which Option to Use?
If you decide to end your current coverage and use a nonforfeiture option, carefully consider which one to pick for your financial goals. It's not a decision you should feel pressured to make on the spot after missing your first premium payment.
If you're not sure what to do, see whether you could use your cash value to cover a month or two of premiums. That would buy you time to consider the other options. When you pick the other options, like surrendering or converting into an annuity, the changes are usually irreversible.
As you plan this decision, consider meeting with a financial professional. They can further explain your options as you can consider what to do next.
