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To buy life insurance, you need to make premium payments. People typically make these payments over many years, but that's not the only option. If you have the resources to do so, another option is to pay all premiums at once with a single premium whole life insurance policy. While this strategy costs more up front and may have tax consequences, it can offer several benefits in the right situation.
What Is Single Premium Life Insurance?
Single premium life insurance is a form of permanent life insurance. This is insurance you can generally keep for your entire life. With most types of permanent insurance, you pay off the policy over many years and even decades, similar to paying down a mortgage. With single premium life insurance, you pay for the entire policy all at once with a single large payment.
Along with a death benefit, your policy could also have a cash value component. Cash value accumulates over time, and can be used during your lifetime. Keep in mind that taking from the cash value can reduce the death benefit for your beneficiaries.
What Are the Different Types of Single Premium Life Insurance?
There are several types of single premium life insurance policies available based on how your cash value and death benefit grow over time:
- Single premium whole life insurance: With a single premium whole life insurance policy, the insurance company offers a guaranteed interest rate, so you can more easily predict what your policy will be worth in the future.
- Single premium universal life: These policies also earn interest, but the rate can go up and down each year depending on market conditions. There is less certainty over how much you will end up with versus single premium whole life insurance.
- Single premium variable life: With a single premium variable life policy, you choose investment funds for your policy. It gains or loses value based on their performance.
What Are the Tax Rules & History?
Permanent life insurance policies offer several major tax benefits. So long as you keep your cash value in the policy, you owe no taxes on its growth. Generally, if you take out money as a loan on most permanent life insurance policies, you can take out your gains without owing taxes, though the insurer could charge interest.
The tax rules for these policies were once so favorable that many wealthy Americans used single premium life as a tax-sheltered investment rather than for its main purpose as insurance protection. They would deposit in a large amount of money upfront for cash value growth while maintaining access to it through loans.
In 1988, tax rules for life insurance changed. If you pay too much upfront (as determined by a government formula), your policy is considered a Modified Endowment Contract (MEC). All single-premium life insurance policies now count as MECs.
What Changed for MECs?
The MEC rules now make single premium life less effective as a tax shelter. When you take cash value out of a MEC, any taxable gains come out first.
Let's say you bought a contract for $100,000, and it now has $120,000 in cash value. If it were a non-MEC policy, you could withdraw $100,000 first without owing taxes and only then decide if you want to take out your $20,000 of taxable gains. But in an MEC policy, you have to take out the taxable $20,000 first before making tax-free withdrawals of your premiums.
Any loans from a MEC follow the same rules. They no longer allow you to take out your gains tax-free. Another disadvantage of a MEC is that if you take out gains before age 59½, you'll owe an extra 10% penalty on the withdrawal.
That said, MECs still can offer some tax benefits. First, as long as you don't access the policy's cash value, taxes on any gains are deferred. Such tax-deferred growth offers a possible advantage over other alternatives. Second, when you die, your beneficiaries would generally receive the death benefit from your policy without incurring income tax on it.
What Are the Potential Benefits of Single Premium Life?
One benefit of single premium life insurance is that you only need to make one premium payment to completely pay off your insurance. After that, you wouldn't have to worry about extra bills coming in each month.
These policies can also offer estate planning benefits by creating a sizable inheritance for your loved ones for which they would not generally owe taxes, provided certain qualifications are met. So long as there is a living beneficiary, death benefits do not go through probate, a state-run court process to distribute property that can take months. With life insurance, your named beneficiary can receive the payout soon after your death.
Besides leaving an inheritance, you could also use single premium life to help cover long-term care costs, such as for staying in a nursing home or assisted living facility, or for at-home nursing care. Some policies let you buy a rider (an extra insurance benefit) that dictates that part or all of your death benefit could be paid out before you die to cover these costs. Payments for long-term care avoid the MEC rules, so you'd receive them without incurring taxes on them.
What Are the Drawbacks?
The up-front cost of a single premium policy is quite high, especially compared with one that you pay off over time. For example, if a 50-year-old wanted to buy a $250,000 policy, they might need to pay $150,000 as the one-time single premium — versus 15 to 20 years of paying an annual five-figure premium, such as $10,000 a year, for example.
The MEC tax rules make single premium policies less effective for taking out money while you're still alive. If you might need that money to fund your retirement expenses or as an emergency fund, it could be more tax-advantaged to use a non-MEC policy, meaning you pay it off over a longer period to meet the government rules.
The drawbacks are even more significant if you end up needing the entire balance back at some point and have to cancel the policy. Not only would you lose whatever you paid for the insurance costs, but some policies also have surrender charges — a penalty for cancelling your policy within the early years. As a result, changing your mind could cost you any growth and even part of your premium while erasing your insurance coverage.
When Can These Policies Make Sense?
- Inheritances: Let's say you're financially secure and receive a lump sum of cash from an inheritance, an employer buyout or some other source. Of course, you could put that money in the bank and let it collect interest. But another choice could be to purchase single premium life insurance. It can be a strategy worth considering if you're already financially stable and don't foresee needing the money soon. That way, the single premium life policy could grow into a sizable amount, which you could then leave to your loved ones when you pass away.
- Family member with special needs: If you're trying to support a family member with special needs, a single premium policy can help to provide a future financial cushion to finance a trust fund for their future care. If you're married, you could potentially increase the amount by using a second-to-die policy, meaning that the policy is based on two lives: your spouse and yourself. That turns your single premium into an even larger death benefit.
- Estate taxes: Very wealthy individuals may want to use single premium life insurance to cover estate taxes. If you leave more than $11.7 million (2021 individual amount; adjusted annually for inflation) to your beneficiaries, the IRS can charge an estate tax rate of up to 40% on what you leave behind, while some states also charge taxes on smaller inheritances. If you're leaving behind illiquid assets like a farm or real estate, this could force your beneficiaries to sell to cover the taxes. By putting some of your savings into a life insurance policy now, you'd be providing your beneficiaries some future liquid cash to prepare for the taxes.
- Long-term care (LTC): These policies can also help if you're concerned about long-term care expenses. One drawback with standalone long-term care coverage is that if you don't need care, you've paid for insurance that you never used. If you combine single premium life with LTC coverage and end up not needing care, your beneficiaries receive the death benefit instead.
- Charitable giving: If you're interested in creating a lasting legacy while reducing your taxable estate, charitable giving is another popular use of single premium life insurance policies. It's possible to gift a policy to a charitable organization or name a charity as a beneficiary, so they receive the death benefit upon your passing. It's important to discuss these options with a financial professional and fully understand the implications before taking any action.
How Do You Get Started Researching Policies?
For single premium insurance policies, you typically need to work with a life insurance company directly to determine what they would offer. While online services may provide quotes for smaller term policies, they usually don't do so for these larger, more complicated policies.
You could reach out to schedule a meeting with a financial representative, who will get to know your financial situation and use that to put together a quote. They could forecast a few options for different premium sizes, as well as if you'd like to add extra benefits, such as long-term care coverage.
There is no cost to get a quote. From there you can see how the numbers would look, including how much of a death benefit your beneficiary would receive from your single premium, the cash value and the future expected growth.
How Can You Fund a Policy?
Cash is typically the simplest way to purchase a single premium insurance policy, but it's not your only option. If you have an existing permanent life insurance policy with cash value, you could do something called a 1035 exchange. This transfers over your cash value and uses it to pay off another policy (the single premium). You might do this because you like the death benefit on a new policy more or want to add long-term care benefits. You wouldn't owe any tax for making the transfer.
If you have money in retirement plans that you would like to use for one of these policies, you cannot transfer the funds directly into a life insurance policy. Instead, you'd need to take it out of the retirement plan first as a withdrawal. If you have a 401(k) or traditional IRA, you'd owe income tax on the entire withdrawal. This would be a sizable tax hit to pay for larger policies, plus it could move you into a higher tax bracket, so there are significant downsides for using these retirement plans to fund a policy.
On the other hand, if you have a Roth IRA or Roth 401(k), you can make withdrawals from these accounts at age 59½ without incurring taxes. These may be better ways to fund a single premium life insurance policy.
Who Can Help With This Decision?
A financial representative can help you run the numbers for a single premium policy and explain the details. You may also want to discuss this strategy with your accountant and your estate plan attorney (if you have one). As a team, these professionals can help make sure your life insurance and estate plan strategy make sense for you.
In a world full of choices, doing your research could help you decide whether the financial security and tax benefits of a single premium life policy are a good fit for your financial plan.