There are a lot of types of life insurance. Some expire. Some act as an investment. Some are for pets. And some offer a refund.
Return of premium life insurance policies do just what they say: When the policy is up, the premiums paid over the previous decades are returned to the policyholder. Tax-free. But while you can avoid taxes with a return of premium policy, there are a few catches.
What is a return of premium life insurance policy?
Let’s start with the basics.
An insurance premium is what you pay monthly or annually to keep a policy active. You pay them for life insurance, car insurance, health insurance — every type of insurance.
How does a return of premium work? It's a standalone life insurance product, or a rider to a traditional term life policy. It adds some peace of mind for people who don’t want to “waste” money on a policy they’ll never “use”. (Note: If you don’t use your life insurance policy, that’s a good thing.)
At the end of the term, your premium payments are returned. There are usually some minimal fees taken out of the refunde, but otherwise you get back everything you put into the policy.
Return of premium policies cost a bit more than traditional policies. You can see a return of premium cost breakdown here. After all, investing premiums, and keeping premiums from outlived policies, are how life insurance companies make money. Higher premiums mean more interest gained before the premiums are refunded.
Return of premium life insurance & taxes
Getting a large lump sum of money usually incurs taxes — think lotto winnings, for example.
But life insurance is surprisingly tax-exempt. There are a few ways taxes affect life insurance, but death benefits are tax-free, and so is a return of premium. That’s because it’s literally just a refund — your money gets returned to you. It’s refunded more or less in the same amount as it was 10, 20 or 30 years previous.
But that’s both a pro and con of return of premium life insurance. You don’t have to pay taxes on the money returned, but you’ve also been paying much more than you would for a traditional policy — and missed out on decades worth of interest by investing the difference. Investing $50 more a month over 30 years adds up.
So is return of premium life insurance worth it?
Which isn’t a very good answer, but it’s the truth. Receiving a sizable chunk of money when you’re at or nearing retirement is nice, especially if you don’t have to pay taxes on it. But you have to consider you’re really just getting back money you already put in. It’s not extra money; it’s money that was already yours.
Getting a premium refund tax-free is enticing. After all, a lot of our financial decisions revolve around lessening our tax burden. But you shouldn’t let that blind you to the flip side of a return of premium policy. You have to take into account not just the tax implications, but the upfront cost (higher premiums) and opportunity costs (missing out on better investment vehicles) that come with them.
Image: Johnny Greig