Limited pay life insurance is a great asset that is often used by those interested in infinite banking or using it for a life insurance retirement plan.
You see, one huge advantage of whole life vs other permanent life insurance products is fixed premiums. When you buy a policy, you know that, no matter how long you need to keep the coverage in place, your premiums will never increase.
It makes budgeting easier and avoids a situation where a dramatic premium increase later in life forces you to give up the coverage.
But there’s something even better than knowing your premiums will never increase—not having to pay any more premiums at all.
Whole life policies are structured so that, after enough premium payments have been paid, a policy becomes “paid up.”
At that point, you get to keep the coverage (and the cash value), but you no longer have any obligation to pay premiums.
For financial planning and budgeting purposes, a paid-up policy is purely an “asset,” without any corresponding “liability” to pay premiums.
The “catch” (if you want to call it that) is that most ordinary whole life policies are set up to achieve paid-up status when the insured reaches an age he or she will probably never see—often 100 or 121 years old.
Except for the small minority of people who live past 100, that means premiums for most ordinary whole life policies are effectively paid for life.
Insurance companies recognize that there are a lot of good reasons why you might want a policy that’s paid-up before your 100th or 121st birthday.
And, with that in mind, some carriers offer an option that lets you pay a life insurance policy in full much earlier.
It’s called “limited pay life insurance,” and it’s designed for folks who are willing to pay more early on to avoid further premiums later in life.
What is Limited Pay Life Insurance?
Limited pay policies are (usually whole) life insurance policies that schedule premium payments over a finite period.
Rather than paying premiums for as long as you live, you make payments over a predetermined period—most often, 10, 15, or 20 years or to age 65.
When the premium period ends, the policy is paid up. Coverage stays in place, cash value continues to grow, but payments from you to the insurance company are no longer necessary.
Limited pay policies are sometimes called “short pay,” “10-pay,” “20-pay,” etc. (however many years the premium term lasts).
Along similar lines, some insurers offer limited pay policies with premiums owed through a specific age (most commonly 65 years old). So, instead of paying premiums for ten or twenty years, you pay until you reach age 65.
A few companies allow policyholders to tailor limited pay policies even further. If an insured’s retirement plan contemplates retiring at age 72, for instance, a whole life policy could be set up to be paid up at precisely that age. Not all insurers allow this level of fine-tuning, though.
As a general rule, the shortest premium period available for limited pay policies is seven years.
If a policy is paid-in-full earlier than that, the IRS considers it a “modified endowment contract” (as opposed to a life insurance policy), and the policy misses out on some of the valuable tax advantages afforded to life insurance.
Some carriers offer single-premium whole life policies, which can be very beneficial under the right conditions. But single-premium whole life serves different purposes and is generally considered a separate creature from limited pay.
Within the insurance industry, “limited pay” is usually understood to refer to whole life insurance policies with shortened premium periods.
Like with any other whole life, you get fixed premiums, a permanent death benefit, and cash value that earns tax-deferred interest.
Guaranteed Universal Life (“GUL”) policies are also “limited pay” in the sense that coverage is permanent, while premium obligations often cease during the insured’s life. GUL, though, is focused almost exclusively around the death benefit and lacks some of the cash value advantages of limited-pay whole life.
Limited Pay Whole Life VS Term Insurance?
Although limited pay whole life and term life insurance both have pre-defined premium periods, the two types of life insurance have significant, fundamental differences.
For one, the coverage provided by a limited pay policy never expires.
For another, limited pay life insurance accrues cash value—term policies don’t.
Term Insurance Ends
When a term life policy’s term ends, you no longer have to pay premiums, which is nice as far as it goes. But you also no longer have life insurance coverage—at least, not under that particular policy.
Conversely, when a limited pay policy’s premium period ends, the policy is paid-up and premium obligations cease—but the coverage stays in place.
Unless you opt to surrender a policy voluntarily, the death benefit remains effective for as long as you need it.
Regardless of how long the insured lives, when death occurs, policy proceeds will be paid tax-free to the designated beneficiary.
Term life insurance is more like a lease because you have to give up the leased “property” (i.e., the death benefit) when the term ends.
Limited pay is more like an installment contract. When the payment term concludes, you own the policy “free and clear.”
How Does Limited Pay Life Insurance Work?
The short answer is that limited pay whole life policies operate like ordinary whole life policies, except you don’t have to pay the premiums as long.
Limited pay policies are guaranteed to reach paid-up status on a specific date (provided all premiums are paid).
So, you’re not relying on investment performance or market conditions, like with some universal life policies.
And as long as all payments are made, a limited pay whole life policy will be paid-in-full when it’s supposed to be.
Cash Value Accumulation
Like other whole life policies, limited pay policies accumulate cash value that steadily increases the longer a policy remains in place. Existing cash value then earns compound interest that grows tax-deferred.
And some limited pay policies issued by mutual insurers are also eligible for dividends that can be used to boost both a policy’s death benefit and its cash value.
These participating life insurance policies pay an annual dividend to policyholders, that can be used to buy paid-up additional insurance, growing both your cash value and death benefit.
Because you’re making fewer total premium payments by shortening the premium period, limited pay policies generally require higher payments. The shorter the period, the higher the payments.
A 10-pay policy will have higher premiums than a 20-pay, for example.
Of course, younger and healthier insureds typically qualify for lower premiums, but the key factors with limited pay are how many payments you will make and how much coverage you are purchasing.
If a policy sets up premiums to conclude at a certain age, the payments depend on the insured’s age when the policy is issued.
For example, a 40-year-old insured who purchases a policy with premiums lasting through age 65 would have 25 years of premiums, but a 50-year-old who purchased the same policy would only pay 15 years of premiums.
In this example, the 50-year-old’s premium payments will obviously have to be higher.
Faster Cash Value Growth
Simply arriving at paid-up status earlier than ordinary whole life policies isn’t the only advantage of limited pay. Because the premiums are increased, limited pay also results in faster cash-value accumulation—often, significantly so.
Basically, since more money is being paid into the policy early on, more gets allocated to cash value.
And, because cash value accrues compounding interest, the increase ends up being greater than a simple dollar-for-dollar comparison of limited pay premiums to ordinary whole life.
Higher Payments = Larger Dividends
Moreover, if a limited pay whole life policy is dividend-eligible, the dividend payments received early in the life of a policy are usually increased, too—because current cash value is one of the factors insurers use to calculate dividends.
If those dividends are invested back into the policy, the growth potential is increased even further.
After a limited pay policy is fully paid-up, the difference in growth starts to balance out. No additional premiums are being paid into the policy, so cash value is no longer increasing due to contributions of “principal.”
However, cash value will continue to earn interest, and eligible paid-up policies still receive dividends when issued by the insurer. And, by that point, policyholders are often ready to use accrued cash value to help fund retirement.
Limited pay policies are eligible for many, but not all, of the same coverage-enhancing riders offered with ordinary whole life policies.
One of the more popular options is to combine a limited pay whole life policy with a long-term care rider.
When the rider is purchased, policy proceeds can be applied toward necessary long-term care costs, with amounts used for long-term care deducted from the eventual death benefit.
Advantages of Limited Pay Life Insurance
The most basic advantage of limited pay whole life is what you might call “peace of mind.”
You get the death benefit fully paid-up sooner, thereby eliminating the risk of losing coverage due to a policy lapse.
You don’t need to worry about not being able to afford premiums later in life if a policy is already paid-up.
This benefit can be particularly important for individuals who need to be certain a policy’s death benefit will be available for loved ones.
Limited pay policies are also an attractive option for people who want coverage that fits within a retirement plan.
By timing a limited pay policy to reach paid-up status around when you plan to retire, you avoid having to pay premiums after you retire—which can be a huge help when adapting to a new retirement budget.
Just as importantly, limited pay polices offer significant advantages if you intend to use policy value to help fund retirement—especially if you’re purchasing a policy later in your career.
Ordinary whole life assumes a long-term timetable. Returns aren’t all that remarkable early in the life of a policy, but over twenty or thirty years, policy growth looks a lot more impressive.
Because larger early premiums boost cash value and facilitate much quicker growth, limited pay returns start to look good much sooner.
Throw in dividends, and a limited pay policy’s cash value can be a solid source of retirement funding, even if you don’t purchase the coverage until later in your career.
Using Cash Value
Policyholders using cash value for retirement have multiple options.
An outright surrender lets you get all the value at once. The downside is that all of the policy growth (the surrender value minus total premiums paid) will be taxable for the year of the surrender.
Alternatively, cash value can be rolled over into an annuity so that taxable growth is received gradually over time, and undistributed amounts continue earning interest.
Or, if you want to keep at least some coverage, you can make partial withdrawals of cash value or take tax-free policy loans.
Life Insurance Loans
Tax free policy loans accrue interest, but your policy is still getting interest on your cash value plus dividends. So, depending on how much cash you borrow against, your policy’s cash value may continue to grow even with an outstanding loan.
Further, the death benefit remains effective, with unpaid loan balances deducted from the policy’s eventual death benefit.
Life Insurance for Kids
On the other side of the age spectrum, limited pay policies can also be a good option for insuring children.
You get to take advantage of the extra-low premiums available with kids’ policies, while securing lifetime coverage for the child.
Upon reaching adulthood, the insured can either keep coverage with no premiums or surrender the policy for its cash value.
Limited Pay Drawbacks
The most obvious, significant disadvantage of limited pay whole life is that you have to pay higher premiums. Depending on the premium term and the insured’s age, the payments can sometimes be a lot higher.
If you don’t have sufficient room in your budget to afford a limited pay policy with the death benefit level you need, you may have to either sacrifice some coverage, stretch the premiums out longer, or cut expenses elsewhere to make up the difference.
In that scenario, many people are better off looking at an ordinary whole life policy or one of the many available universal life options—depending on individual circumstances.
Notably, though, some insurers offer limited pay whole life policies with term riders providing supplemental coverage for a defined period (often ten years) after a policy is issued.