Usually, the purpose of life insurance is to provide a substantial death benefit to loved ones. However, depending on the type of policy you have, it can come with additional advantages. One of these benefits is the ability to create cash value, which you can borrow as a loan or utilize to pay off premiums in the long term.
Whole life insurance policies allow the policyholder to grow cash value. However, if the individual wants to expedite this financial growth, he or she can invest in paid-up additions (paid up additions). In this article, we’re going to break down what paid up additions are, how they work, and whether they are a good investment.
What are Paid-Up Additions?
When buying a life insurance policy, you have to make premium payments each month over many years. With whole life insurance, you’ll continue to pay these premiums until you die. However, a paid-up addition works like a mini version of a life insurance policy that is paid in full as soon as you create it.
A paid up addition has to be added to a current whole life insurance policy; it can’t be a singular entity. There are two ways that you can create a paid up addition within your policy. First, you can use dividends from your cash value. In many cases, the insurance company will do this automatically, rather than cutting you a check whenever it occurs.
The second method of creating a paid up addition is to buy it directly as a rider. In this case, you are adding money from a different account (i.e., a checking account) to cover the cost and to increase your policy’s cash value.
To further understand the mechanics of a paid-up addition, let’s break down how whole life insurance works.
The Basics of Whole Life Insurance
When choosing a policy, you have to determine the size of your death benefit. For example, you may decide to get coverage of $1 million to pay to your spouse or adult children when you pass.
Since life insurance companies are a business, they aren’t going to pay a death benefit for free. Insurers minimize their financial risk by charging monthly premium payments. A majority of each payment goes toward the death benefit, while a small portion goes toward the policy’s cash value. The amount you pay each month is determined by various risk factors, such as any health problems you may have, your age or your lifestyle.
Over time, the portion of your premiums that goes to the cash value will build. The insurance company invests this money, which is how it produces dividends. Unless you opt to receive these dividends as payments, they will go back into the cash value to help it build faster.
With each whole life insurance policy, there is a point when the plan is “paid-up.” This point is when you’ve contributed an amount equal to your death benefit. As you get closer to reaching this point, the portion of your premiums that add to the policy’s cash value increases.
Once the life insurance policy is paid up, the majority of your contributions will go into the cash value. Depending on the size of your death benefit, it could take decades for your policy to get paid up, which is why the cash value can take a long time to build any substantial value.
A paid up addition works the same way, except the policy is paid-up immediately. Basically, you’re buying a small version of whole life insurance with a mini death benefit.
The Benefits of Paid-Up Additions
There are many benefits of paid-up additions, and they can be valuable tools for financial growth and wealth management. Let’s break down the various advantages that come with paid up additions.
Increase Your Plan’s Death Benefit
Since these mini policies are added to your current coverage, you can increase your death benefit. In some cases, this system can provide you with some strategic advantages.
For example, perhaps you want to choose a smaller death benefit upfront so that your main policy will get paid up faster. However, to ensure that your loved ones still receive a significant payment once you’re gone, you can increase the benefit with paid up additions.
The amount a paid up addition will add to your insurance policy depends on several factors, but your age will affect it the most. For example, a paid up addition for a 30-year-old may receive up to eight dollars for every dollar spent. By comparison, a 50-year-old may only receive a three-to-one ratio.
Build an Immediate Cash Value
One of the primary issues with a whole life insurance cash value is that it can take years to build. Since you’re allowed to borrow against your cash value, you may want it to grow faster so that you can tap into it sooner.
Since a paid-up addition is funded immediately, the portion that goes into your cash value is available whenever you want it. This means you can access it whenever you like, rather than waiting years for it to accumulate.
What happens with paid-up additions is that you create a compounding effect. Since the paid up addition qualifies to earn dividends, your cash value will only gain more interest as you contribute funds to it. The more often you add a paid up addition, the more this compounding effect works in your favor.
So, rather than waiting years to accumulate interest, you can accelerate the process and take advantage of your plan’s cash value that much sooner.
Another compelling reason to take advantage of paid up additions is that the funds grow tax-deferred. This means that you don’t have to pay income or capital gains taxes on interest earnings.
Best of all, if you borrow against your cash value, you still don’t have to pay any taxes. This is because the insurance company uses your policy as collateral, not withdrawing funds from it directly.
In this way, your policy’s cash value works similarly to a traditional IRA. So, you can use paid up additions as a financial tool to build money for retirement. Since this creates a compounding effect, your funds will grow much faster than they would otherwise.
Considerations of Paid-Up Additions
While paid up additions can sound like an easy way to build wealth, they do come with some caveats. Before contributing funds to your life insurance policy, be sure to consider these factors.
One disadvantage of paid up additions is that they vary significantly between insurance companies. Insurers make money off these riders by charging fees every time. Typically, the cost will be between five and ten percent.
While it’s tempting to assume that a plan with lower fees will be better, that’s not always the case. Instead, you have to compare the cost of the charge to the amount of interest and dividends you’ll receive from the paid up addition. In some cases, the rider may be worth a higher price because you’ll earn more in the long run.
Qualifications and Restrictions
If you currently have a whole life insurance policy, you may or may not be able to add a paid up addition rider. Again, the variation between insurers can be broad, which can make this process relatively complicated. As a rule, the younger and healthier you are, the easier it is to add this kind of rider.
If you don’t have life insurance and are trying to buy a policy, you’ll want to incorporate a paid up addition rider upfront. Depending on the circumstances, the insurance company may restrict the size of your death benefit and the amount of interest you’ll earn with the base policy.
The reason for these restrictions is to minimize the company’s financial risk. While paid up additions can be beneficial, insurers aren’t going to give away free money without a few checks and balances.
In some cases, you may not be able to get a paid-up addition. If that does happen, you’ll want to check other companies to see if they have similar restrictions.
While paid up additions can sound appealing at first, they do require some planning to maximize their potential. You never want to contribute money to an account with no reason behind it. So, before signing up for paid up additions, consider these questions:
- How much can you pay into a paid-up addition?
- When do you plan to withdraw money from your cash value?
- Do you want to increase your death benefit?
- How does a paid up addition compare to other investment options?
For example, if you’re not planning on dipping into your cash value for a while, then paid-up additions may not be necessary. Alternatively, if you want to build a more significant nest egg for retirement and have disposable income right now, a paid up addition may be a considerable investment strategy.
Before finalizing any paperwork, we recommend talking with a financial advisor to compare options to determine whether a paid up addition is ideal for your situation.
Contact NextGen Insurance Today
Because paid-up additions can be complex, it helps to have a professional by your side. We’ll help you compare plans and rates to figure out which one works best for your needs. Whether you’re trying to build a bigger death benefit or plan for retirement, we can make it easier to find a policy. Contact us today to find out more.