kate_sept2004/GettyImages; Illustration: Hunter Newton/Bankrate
Choosing life insurance can be overwhelming, with so many options available. One type that stands out for its unique structure is single premium life insurance, which typically refers to permanent life insurance. Unlike traditional insurance that requires ongoing payments, single premium life insurance is funded with a single, lump sum payment and provides a guaranteed death benefit. This simplicity can be especially appealing if you don’t want to worry about future premiums.
Imagine being able to secure your loved ones’ financial future with just one payment — no more monthly bills or annual renewals. But before making such a large upfront investment, it helps to understand both the benefits and potential drawbacks. Let Bankrate’s expertise guide you through everything you need to know about single premium life insurance and help you decide if it’s right for you.
What is single premium life insurance?
Single Premium Life Insurance (SPL) is funded with a one-time, upfront lump sum payment and provides a guaranteed death benefit to the policyholder’s beneficiary. Unlike most life insurance policies, such as term life insurance, which require ongoing premium payments monthly, quarterly, or annually, SPL insurance simplifies the process by requiring only a one-time payment. This strategic approach allows policyholders to quickly accumulate cash value that can be accessed through policy loans or withdrawals, providing a source of funding throughout their lifetime.
Single premium life insurance is often preferred by wealthy individuals for its savings benefits rather than income protection, which is the primary objective of many life insurance buyers. This type of insurance is especially useful for those looking to maximize their investment quickly. While term and whole life insurance typically require regular premium payments over a period of time, single premium life insurance does not require ongoing payments and offers an easy and efficient option to secure a large death benefit and accumulate cash value.
Lump sum options come in three forms: single premium whole life insurance, universal life insurance, and variable life insurance.
- Single payment whole life insurance. It falls under the category of whole life insurance and is a type of permanent life insurance. With single premium whole life insurance, you pay a lump sum for a policy that accumulates cash value over time and earns a fixed amount of interest.
- Universal life. Single premium universal life insurance is similar to whole life insurance in that the cash value of the policy grows steadily. The difference is that universal life insurance is generally more flexible than whole life insurance and accumulates cash value in a different way.
- Variable life insurance. Variable life insurance also accumulates cash value, but the cash value grows at a variable rate. There are limited investment options (such as mutual funds), and the policy’s performance may exceed or fall short of market expectations.
The pros and cons of single premium life insurance
Because there are many different options for life insurance and lump sum life insurance requires a large upfront investment, you need to understand both the pros and cons of choosing this insurance.
Benefits of single premium life insurance
- One-time payment: One of the biggest benefits of single premium life insurance is the convenience of a one-time payment. By paying the premium in a lump sum, policyholders don’t have to worry about ongoing premium payments. This approach simplifies the financial planning process and ensures that the policy remains in effect without the risk of lapse due to late payments.
- Faster cash value accumulation: Lump sum life insurance provides immediate access to cash value, whereas traditional insurance can take years to accumulate sufficient cash value. This immediate cash value can be an important source of funds that policyholders can use to take out loans or withdraw money as needed. The accelerated accumulation is especially beneficial for those looking to use their insurance for investments or emergency funds.
- Death Benefit Guarantee: With single premium life insurance, your death benefit is guaranteed from the moment the policy is paid. Because the policy is paid immediately, there is no risk of it lapse due to non-payment. As long as the value of the policy is not reduced to the lapse point through significant borrowing or withdrawals, your beneficiaries will receive the tax-free death benefit. This guaranteed payment gives you peace of mind knowing your loved ones’ financial security is secure.
If you are in a good financial position and want to ensure that you receive the full payment of your life insurance for your beneficiaries, lump sum life insurance may be an option worth considering. This method of taking out life insurance also gives you peace of mind as you know exactly what to expect in the future in terms of the sum insured and payouts.
Disadvantages of lump sum life insurance
- Large upfront payment: One of the main drawbacks of lump sum life insurance is the large lump sum that must be paid into the policy. This large initial payment can be a financial burden for many people and can be out of reach for those without sufficient savings.
- In the event of premature death of the insured, no refund will be given. If the policyholder dies shortly after purchasing the policy, there is no lump sum refund, meaning the policyholder ends up paying more than they would if they paid smaller premiums over time. This is like paying up front for a lifetime gym membership only to discover that circumstances will prevent you from using it any time soon.
- No additional contributions are allowed: Unlike other life insurance policies that allow you to make additional contributions over time, single premium life insurance doesn’t offer this flexibility. Once you’ve made your initial payment, you can’t add to the benefit later. This lack of flexibility can be a drawback if your financial situation changes and you want to put more money into your policy.
- High surrender fees: If you cancel your policy early, you may be subject to significant surrender charges. These charges can significantly reduce any benefits you receive, making canceling your policy early a costly decision. This is similar to the high penalties you may incur if you try to break a long-term policy.
- Tax issues: Single premium life insurance policies are typically classified as Modified Whole Life Contracts (MECs). This classification comes with certain tax implications, particularly with regards to handling loans and withdrawals from the policy. MECs offer some tax advantages, but they also come with potential tax consequences that you should be aware of. We’ll discuss these tax issues in more detail later, but it’s important to know they exist in advance.
If you don’t have the savings to pay your SPL premiums upfront, there are other payment options for taking out life insurance. Paying for life insurance in monthly installments is one of the most common options. Paying for life insurance in installments can also be the best option for your beneficiaries, as you can get more coverage through multiple payment options. A policy with multiple payment options can give you and your beneficiaries peace of mind about what to expect in terms of financial security when the claim is paid out.
What is an Amended Donation Agreement?
A Modified Whole Life Contract (MEC) is a type of life insurance contract that has special tax consequences. It occurs when too much money is put into a life insurance policy, such as a lump sum life insurance policy, too quickly. Here’s what you need to know.
1. Lump Sum Payment Policy: With lump sum life insurance, you pay a large lump sum up front, which is the full amount of the insurance, unlike traditional insurance, where you pay smaller amounts over time.
2. IRS Regulations: The IRS has rules that prevent people from using life insurance as a tax avoidance strategy. One of those rules is the “seven-year payment test.” This test compares the amount you put into the policy during the first seven years against certain limits. If you put in more than the amount allowed, the policy becomes MEC.
3. What happens in the case of MEC:
- Withdrawals are subject to tax: Life insurance typically allows you to withdraw money tax-free up to your cost basis (usually the total amount of premiums paid), but with an MEC contract, withdrawals are taxed as ordinary income on a last-in, first-out (LIFO) basis.
- Loans are subject to tax: Loans secured by the policy’s cash value are also taxable, and if you’re under age 59 1/2, you may have to pay an additional 10 percent penalty.
4. Why is this important: If your policy is classified as an MEC, you will lose some of the tax benefits. This doesn’t mean that single premium life insurance is a bad idea, but it does mean that you need to understand the tax implications.
In summary, lump sum life insurance can be a modified endowment policy because it is paid in full up front. This changes how the policy is taxed, especially when you access the cash value. Knowing this can help you make better decisions about life insurance and your overall financial planning. If you have questions, it’s best to speak with a financial advisor who can explain how these rules apply to your situation.
Is single premium life insurance worth it?
Single premium life insurance can be a worthwhile option in certain economic situations. Here are some scenarios where it’s worth considering:
- Inheritance and life insurance needs: If you have recently inherited a large sum of money and are in need of life insurance, a lump sum policy can provide you with immediate coverage without the need for ongoing payments.
- Wealthy: For those who have already maxed out their retirement accounts, such as 401(k)s and IRAs, single premium life insurance can provide a way to further diversify and secure their financial plan.
- Estate Planning: For individuals with large estates, this type of insurance can help reduce inheritance taxes by using a portion of their assets to purchase life insurance, thus ensuring that their heirs receive a larger share of their estate.
- 1035 Exchange: If a policyholder has a policy (or multiple policies) with a large cash value and does not want to pay any more premiums, they can make a 1035 tax-free exchange for a lump sum policy, which allows them to receive the coverage and not have to pay any more premiums.
But for most people, lump sum life insurance is less appealing due to its drawbacks, including high upfront costs and the tax implications of a modified entire life contract (MEC). You may be better off purchasing traditionally funded life insurance and investing in other vehicles, such as an IRA account.
It is always wise to seek advice from a financial professional to determine the best strategy for your own unique financial situation.
