Single premium life insurance is a type of policy where a single, lump-sum payment is used to fund the entire policy, offering lifelong coverage without the need for ongoing premium payments. While not as common as traditional life insurance policies, single premium life insurance can be an easy option for those looking to invest a large sum of money upfront. However, it is important to consider alternatives, especially maintaining liquidity or having flexible payment options is a priority.
What is single premium life insurance?
Single premium life insurance is a type of life insurance policy that requires a one-time, lump-sum payment made up-front in exchange for a guaranteed death benefit. Unlike traditional life insurance policies that typically require monthly or annual premium payments over a set period, single premium life insurance eliminates the need for ongoing payments. This means that once the initial lump-sum payment has been made, the policyholder is covered for life without worry of future premium payments. This differs from traditional policies, where regular premiums must be maintained to keep the coverage active.
How does single premium life insurance work?
To better understand how single premium life insurance works compared to traditional life insurance, let’s look at an example.
In a traditional life insurance policy, a policy holder might pay $500 annually over 20 years, totaling $10,000 in premiums. The policyholder must continue to make the premium payments for the entire length of the policy to guarantee the death benefit payment. In contrast, with a single premium life insurance policy, the policyholder makes a one-time payment of $25,000 upfront, for example. The single payment could guarantee a death benefit payment of $75,000, with no further payments required to maintain the policy.
In both scenarios, the policyholder secures the same death benefit, but the payment structure and financial commitment differ significantly.
Types of single premium life insurance
There are different types of single premium life insurance policies, each designed to meet different financial goals and needs. Understanding these policy types can help you choose the one that aligns best with your individual needs and situation.
Single premium whole life insurance
Single premium whole life insurance is a subcategory of single premium life insurance that offers the added benefit of building cash value over the life of the policy. This cash value can grow or fall at a guaranteed interest rate, providing a stable and predictable accumulation. With this type of policy, not only do you secure lifelong coverage with a single payment, but you also have the potential to access the accumulated cash value if needed.
Single premium variable life insurance
Single premium variable life insurance is different from other single premium coverage in that the policy’s cash value grows at a variable rate based on the underlying performance of the investment options selected. This means that the cash value of the policy can increase or decrease depending on market conditions, offering the potential for higher cash value compared to more stable, guaranteed interest rate policies. With this type of coverage, policyholders can benefit from market growth but should also be prepared for the associated risks in keeping the policy in-force.
Single premium universal life insurance
Single premium universal life insurance is like single premium whole life insurance but offers coverage until you reach a certain age rather than for a fixed number of years. This type of policy combines the benefits of a single premium payment with the flexibility and longevity of universal life coverage. As with whole life insurance, it builds cash value over time, but it provides lifelong protection up to a specified age, ensuring coverage throughout your lifetime.
Single premium life insurance and modified endowment contracts (MECs)
In the past, single premium life insurance policies were often used as tax shelters. Meaning, people could make a large, one-time payment into these policies, allowing the cash value to grow tax-deferred. They could then access these funds through loans or withdrawals without paying taxes right away. To address this loophole, congress passed a law in 1988 that classified these policies as Modified Endowment Contacts (MECs). This change meant that withdrawals and loans from these policies would be taxed differently, reducing their appeal as tax shelters and ensuring they were primarily used for life insurance protection.
Single premium life insurance policies are considered MECs because they typically involve a large, upfront payment that exceeds the limits set by the IRS for regular life insurance policies.
The criteria that help determine if a life insurance policy is classified as an MEC are as follows1:
- The policy was entered into after June 20, 1988
- It must meet the statutory definition of a life insurance policy
- The policy must fail to meet the Technical and Miscellaneous Revenue Act of 1988 (TAMRA) “seven-pay test”
Tax implications
Single premium life insurance policies classified as Modified Endowment Contracts (MECs) come with specific tax implications that differ from standard life insurance policies. Some tax rules to be aware of:
- Taxable distributions — withdrawals or loans from an MEC is taxed on a “last in, first out” (LIFO) basis. This means any earnings are taxed before you receive your original premium payments back.
- Early withdrawal penalties — If you take distributions from an MEC before the age of 59 ½, you may face an additional 10% federal tax penalty on the earnings.
- Tax deferred growth — The cash value within an MEC still grows tax-deferred, meaning you do not pay taxes on the growth if it remains in the policy.
- Tax-free death benefit — The death benefit paid out to beneficiaries remains tax-free, just like with traditional life insurance policy, even if the policy is classified as an MEC.
What are the benefits of single premium life insurance?
Single premium life insurance offers several advantages that make it an appealing option for certain financial goals:
- Guaranteed cash value — cash value grows at a fixed or variable rate, depending on the type of policy.
- Death benefits — single premium life policies provide a guaranteed death benefit to beneficiaries, ensuring financial protection and peace of mind for loved ones.
- One-time payment — ease and simplicity of one lump-sum single payment to fund the policy.
- Loan access — Policyholders can borrow against the accumulated cash value of the policy.
- Estate planning — single premium life insurance provides liquidity to cover estate taxes or other expenses, ensuring more of the estate is passed on to heirs.
What are the disadvantages of single premium life insurance?
It is important to consider the potential drawbacks:
- Affordability — the requirement of a single large lump-sum payment may not be affordable to everyone.
- Risk of overpayment — If the lump-sum payment exceeds what is necessary to meet insurance needs, you might end up investing more money than required.
- Limited access to funds — while you can borrow against it, accessing the cash value might involve restrictions or impact the policy’s performance or death benefit.
- Contribution limits — Single premium life insurance policies have limits on the amount you can contribute without triggering Modified Endowment Contract (MEC) status.
Alternatives to single premium life insurance
Given that single premium life insurance can cost more than other options and comes with specific tax implications, it may not be the best option for everyone. For those who find the upfront cost prohibitive or are concerned about tax consequences, whole life insurance policies could be an alternative. Whole life insurance provides lifelong coverage* with flexible premium payments and the benefit of building cash value over time. Unlike single premium policies, whole life insurance allows for regular premium payments, making it more manageable for many individuals. This type of policy also offers a guaranteed death benefit and cash value growth for those looking for balance between affordability and comprehensive coverage.
Learn more about whole life insurance.
*As long as required premium payments are maintained.
WEB.5871439.07.24
