Cash-value policyholders must consider taxes when they withdraw or borrow cash. By Kimberly Lankford, Contributing Editor September 1, 2009 EDITOR'S NOTE: This article was originally published in the July 2009 issue of Kiplinger's Retirement Report. To subscribe, click here.Like many retirees and workers approaching retirement, you may be holding a life insurance policy with a large cash build-up. As your needs shift from protection to income, it could be time to tap the assets, especially if the market decline has downsized your portfolio. There are several ways to withdraw your money. Depending on your withdrawal choice, your death benefit could change -- and so can your tax liability. Ed and Carol Maier, of Frisco, Tex., bought life insurance soon after their son was born in 1973. The Maiers chose a Northwestern Mutual policy that offered a benefit beyond insurance coverage: a cash-value account that would grow over time. "This policy protected us if something tragic were to happen, and it provided a good way to build assets for retirement," Ed says. Advertisement Today, Ed and Carol are in their early sixties. They're more interested in the retirement-savings feature than the death benefit. Ed works part-time as a self-employed executive coach, but plans to cut back over the next ten years, when the policy's cash value will start to make a big difference. At that point, the Maiers can make tax-free withdrawals up to the amount they've paid in premiums and can then borrow more money from the account. When they die, the loan amount will be subtracted from the death benefit, but their heirs won't pay taxes on the death benefit. Unlike term insurance, cash-value policies, also known as permanent insurance, can continue for a policyholder's lifetime. It usually doesn't make sense for people in their fifties or sixties to buy a cash-value policy just to build up their savings. "It's a long-term investment," says Scott Berlin, senior vice-president in charge of individual life at New York Life. The cash-value policy works best, he says, if you can keep it for at least ten years before tapping it for retirement. At that point, much of the upfront fees have been paid and the cash value can really start to grow. If you already hold a cash-value policy that you bought 20 or more years ago, your assets may have grown substantially. For instance, a 45-year-old man who paid $5,815 a year for a Northwestern Mutual policy with a $250,000 death benefit starting in 1989 would have nearly $208,000 in cash value in 2009. Meanwhile, his death benefit would have grown to nearly $430,000. Advertisement There are three main types of cash-value life insurance: whole life, universal life and variable universal life. The Maiers have a whole-life policy, the most traditional form of permanent insurance. You pay a fixed annual premium, and you're guaranteed a minimum cash value and death benefit every year. Policyholders usually end up with more than the guarantee. The extra money comes from dividends, which are credited to policyholders based on the performance of the insurer's general account. During the policy's life, you can reinvest the dividends, use them to pay premiums or receive them in cash. The Maiers reinvested all of their dividends and figure their account has grown by an average of 7.5% a year since they bought the policy. "We view it as a conservative, substantially risk-free investment," says Ed. Universal-life policies are more flexible than whole-life insurance. You build up a cash value, but your premiums are not fixed. You can pay a bigger premium if you want a larger cash portion. At some point, you may have accumulated enough in your cash-value portion to cover the premiums. Advertisement The insurer usually promises that a minimum level of interest will be credited to the account every year -- 3% a year, for example. You may receive more if the insurer's chosen investments do well. (The cost of insurance and expenses are deducted from the account so you don't necessarily get a 3% return.) With a variable universal-life policy, you can vary your premium yearly as you can with universal life. But the cash value is invested in mutual-fund-like separate accounts that you choose. There's usually no minimum guarantee and the cash value can change, depending on the funds' performance. If you hold a universal-life or a variable universal-life policy, ask for an "in-force illustration" to make sure that your premiums still support the cost of insurance and expenses. Often, a company will charge a lower premium because it assumes that the cash value will cover some expenses. But if the account has lost value, the expenses may eat away at the cash value and the policy could lapse. You may need to boost your premiums to keep it in force. Drawing the Cash in Retirement Policyholders regularly receive statements showing the cash value. Note that any withdrawal will decrease your death benefit. Advertisement The tax-smart strategy for all of the policies is to first withdraw up to the amount you've paid in premiums. You will not pay any tax on that withdrawal. If you need more cash, you'll get the biggest tax savings if you take the additional money as a policy loan rather than as a withdrawal. You won't have to pay taxes on the loan as long as the policy is in force when you die. If you withdraw the money instead, you'll pay ordinary-income taxes on all of the gains above the premiums paid. If you take a loan, your death benefit will decline. If you're already retired, it's probably not worth repaying the loan because you're unlikely to need a higher insurance amount. Also, you won't have many more years to benefit from tax-free growth in the account. When you die, the loan amount is deducted from the death benefit. You need to keep close track of your remaining cash value, withdrawals and loans. In many cases, your premiums will be paid from the cash value. However, the increase in cash value is based on interest-rate and investment assumptions. If those assumptions are overly optimistic, there may not be enough money in the policy to cover the insurance costs. If the policy lapses while you have an outstanding loan, you could end up with a big tax bill. Don't rush to take cash if you don't need it. There are no required minimum distributions from life insurance policies. The Maiers don't need the extra money right now, so they're continuing to reinvest the dividends as a way to boost the fixed-income portion of their overall portfolio. The Consumer Federation of America's Evaluate Life Insurance service (www.evaluatelifeinsurance.org) can help you assess your options and figure out how much your policy is actually earning. The service costs $75 for the first illustration and $55 for each additional illustration. For more authoritative guidance on retirement investing, slashing taxes and getting the best health care, click here for a FREE sample issue of Kiplinger's Retirement Report.