Overview

Permanent life insurance products—whole life, traditional universal life, and indexed universal life—include a cash‑value component that grows over time. That cash value can be accessed through withdrawals or policy loans to help pay for goals such as college, a supplemental retirement income stream, a business buy‑sell, or estate liquidity. This dual function (protection plus savings) is why some people treat a policy as a goal‑funding tool.

In my practice advising clients for more than 15 years, I’ve seen this strategy work well for particular situations and fail when it’s used as a one‑size‑fits‑all replacement for other savings vehicles. Below I describe when it makes sense, the tax and contract rules to watch, common pitfalls, and practical steps to evaluate whether a cash‑value life policy should be part of your plan.

How cash‑value life insurance actually works

  • Premiums: You pay premiums; a portion covers mortality charges, fees, and cost of insurance; the remainder goes to the policy’s cash value.
  • Cash value growth: Cash value grows either at a guaranteed rate (whole life), a declared rate (universal), or according to an index crediting method (indexed universal life). Growth is generally tax‑deferred (see Tax rules below).
  • Accessing cash value: You can access cash value via withdrawals (often up to basis tax‑free), policy loans (generally not taxable while the policy remains in force), or by surrendering the policy to receive the surrender (cash) value.
  • Death benefit: The policy still provides a death benefit to beneficiaries; unpaid loans reduce the death benefit.

For a concise explanation of how the cash value component is defined, see our glossary entry on cash value (internal link).

When it makes sense — common, realistic scenarios

1) Supplemental retirement income for disciplined savers

  • Use case: Clients who’ve maxed retirement accounts or need a tax‑efficient distribution source that doesn’t affect Social Security earnings tests or certain means‑tested benefits. Policy loans are typically not reported as taxable income while the policy stays in force.
  • Why it works: Loans and withdrawals, when managed, can provide a flexible income source with different tax treatment than ordinary distributions. (See Tax rules below.)

2) Funding a child’s education without touching investment portfolios

  • Use case: Families who want predictable access to funds with fewer market dips than a taxable portfolio; some families use policy loans to preserve long‑term investments.
  • Why it works: Cash value can be borrowed against and repaid on a flexible schedule. But compare to 529 plans, which offer tax advantages for qualified education expenses.

3) Business uses: buy‑sell funding, key‑person liquidity, or executive benefits

  • Use case: Small business owners who need a prearranged source of funds to complete a buy‑sell, pay a key employee’s severance, or provide executive split‑dollar arrangements.
  • Why it works: Life insurance can be structured to provide liquidity when the business needs it most.

4) Estate liquidity and equalizing inheritances

  • Use case: Owners of illiquid estates (real estate, family business) who need cash to pay estate taxes or provide equal inheritances without forcing asset sales.
  • Why it works: A life insurance death benefit provides tax‑free proceeds to heirs and can be held in trust for estate planning purposes. See our related post on using life insurance for estate liquidity (internal link).

5) Situations where creditor protection may be important

  • Use case: Certain states provide creditor protection for life insurance cash values; high‑net‑worth individuals sometimes use policy design as a component of asset protection.

Tax rules and important traps to avoid (current to 2025)

  • Tax‑deferred growth: Cash value accumulates tax‑deferred while the policy remains in force (IRS guidance on life insurance taxation). Withdrawals up to basis are generally income‑tax free; loans are typically not taxable while the policy is inforce because they are treated as debt rather than distributions (IRS).
  • Modified Endowment Contract (MEC): If a policy becomes a MEC—because it was funded too rapidly—the tax treatment changes. Distributions and loans are taxed on a last‑in, first‑out (LIFO) basis and may be subject to ordinary income tax and a 10% penalty if taken before age 59½ (IRS — MEC rules). Ask for the policy’s MEC status before you buy.
  • Policy lapse and taxation: If a policy lapses with an outstanding loan, the loan amount above your cost basis becomes taxable income (IRC Sec. 72). Surrender or lapse can trigger taxes.
  • Estate inclusion: The death benefit may be includible in the insured’s gross estate for estate tax purposes if the policy was owned by the insured at death. Using an Irrevocable Life Insurance Trust (ILIT) is a common way to keep proceeds out of the estate (consult estate counsel).

Authoritative sources: Internal Revenue Service (irs.gov) and the Consumer Financial Protection Bureau (consumerfinance.gov) provide details on taxation and consumer protections for life insurance. See IRS guidance on life insurance taxation and MECs (irs.gov) and CFPB consumer advice on life insurance (consumerfinance.gov).

Pros and cons — an at‑a‑glance assessment

Pros

  • Dual purpose: protection plus a savings/borrowing vehicle.
  • Tax‑deferred growth; loans often not taxed while policy is in force.
  • Predictable elements in guaranteed products (whole life).
  • Useful for business planning and estate liquidity.

Cons

  • Higher initial costs than term life (fees, mortality charges, surrender charges).
  • Returns often lower than pure investment accounts after fees.
  • Policy loans and withdrawals can reduce death benefit and risk lapse.
  • Potentially complex tax traps (MEC, lapse taxation).

How to evaluate whether it’s right for you (practical checklist)

  • Define the goal clearly: college, retirement bridge, buy‑sell funding, estate liquidity, etc.
  • Run alternative scenarios: compare after‑fee investment returns, a 529 plan for education, Roth IRA for retirement, or a taxable brokerage account.
  • Ask for an in‑force illustration and multiple guaranteed and non‑guaranteed projections.
  • Confirm MEC status and any premium‑funding limits.
  • Review fees, surrender schedule, cost‑of‑insurance and how charges are assessed.
  • Check insurer financial strength (AM Best, S&P) and policy ownership/beneficiary design for estate planning.
  • Consult a tax advisor about your specific tax situation and a licensed insurance professional about product design.

Common mistakes I see in practice

  • Treating cash‑value life insurance as a short‑term savings vehicle — policies need time to accumulate meaningful cash value.
  • Funding too aggressively and unintentionally creating a MEC.
  • Borrowing without a repayment plan, which can cause the policy to lapse and trigger a taxable event.
  • Ignoring lower‑cost alternatives for pure savings goals (see Alternatives below).

Alternatives to consider

  • 529 plans for education (state tax benefits and qualified withdrawals tax‑free).
  • Roth IRAs and traditional IRAs for retirement savings (Roth offers tax‑free qualified distributions).
  • Taxable brokerage accounts for flexibility and usually lower fees.
  • Term life insurance paired with a separate investment account for protection + growth at lower cost.

For a detailed look at whether term or permanent coverage fits, see our article on choosing between term and permanent life insurance (internal link).

Practical example (anonymized)

A small business owner in my practice used an indexed universal life policy to fund a buy‑sell agreement. She paid consistent premiums for 10 years, after which cash value had grown enough (net of fees and loans) to make a tax‑efficient loan to fund a partner’s buyout while preserving other business assets. The strategy required careful design, attention to the policy’s cost‑of‑insurance as she aged, and regular reviews to avoid a MEC classification.

How to proceed if you’re interested

  1. Clarify the goal and timeline.
  2. Gather quotes and in‑force illustrations from multiple carriers.
  3. Run side‑by‑side comparisons with alternative savings vehicles.
  4. Review MEC rules and request a written explanation of how loans affect the death benefit.
  5. Work with a fee‑or‑commission‑transparent advisor and a tax professional.

Closing summary

Using insurance as a goal‑funding tool can make sense when you need a combined protection and liquidity solution—especially for business planning, estate liquidity, or a supplemental income source—but it’s not automatically the best choice for routine saving. The key is clear goals, realistic projections, and professional review.

This page is educational and not individualized financial or tax advice. Your situation may be different; consult a licensed insurance professional, a tax advisor, or an estate attorney before implementing any strategy.

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Professional disclaimer: Educational content only. Consult a licensed advisor for personalized recommendations.