Reduced paid-up insurance is a nonforfeiture option that whole life insurance companies provide to their policyholders.
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If you own a whole life policy, the reduced paid-up option would allow you to give up your existing coverage and instead receive a guaranteed death benefit that needs no additional payment of premiums. Permanent life insurance companies also allow policyholders to utilize other nonforfeiture options that include cash surrender and extended term insurance.
What is reduced paid-up insurance?
If you have whole life insurance and no longer want to pay premiums for your policy, you can either opt to surrender it and receive the cash value or use the accumulated cash value to fund reduced paid-up insurance coverage. Reduced paid-up insurance would allow the death benefit to remain in place without you being required to pay any future premiums. However, the death benefit is reduced to the amount of cash value that you had in your original life insurance policy.
Life insurance companies calculate the reduced coverage based on the number of premiums you have paid, the total cash value in the policy and your age. Usually, the amount of cash value directly reflects the amount of reduced paid-up coverage you would receive.
For example, you may pay $2,000 per year for 20 years and have an aggregate cash value of $30,000 in a life insurance policy. If you decide to convert to reduced paid-up insurance, you may be able to receive a $30,000 guaranteed death benefit for the rest of your life without having to pay premiums.
Reduced paid-up insurance is only available for whole life insurance and not term insurance policies since these plans do not have a cash value. Additionally, a life insurance company will usually require three years of premiums before your policy would become eligible for reduced paid-up insurance.
Difference between paid-up additions and reduced paid-up
A paid-up addition is extra life insurance that you can purchase using dividend payments from the policy. The amount of paid-up additions you purchase directly increases the death benefit of your current policy.
Paid-up additions and reduced paid-up insurance also differ in that reduced paid-up options are included with most whole life insurance policies. In contrast, paid-up additions are considered supplemental to your original policy. This means that your insurer will require you to add the "paid-up" rider, which could merit charging larger premiums to your policy when you first purchase life insurance coverage.
Reduced paid-up insurance vs. other nonforfeiture options for life insurance
A nonforfeiture option is a clause in your policy that allows you to receive full or partial benefits from your life insurance if the policy lapses or you want to cancel the plan. Reduced paid-up insurance is a nonforfeiture option that is included with your life insurance coverage. Other nonforfeiture options that are provided by most insurers include:
- Cash value surrender
- Extended term insurance
Cash value surrender is the most basic nonforfeiture option that is available. In this case, you would forfeit your life insurance for the cash value that has built up in the policy. Before issuing the cash value payment to you, any outstanding loans or premiums owed would be deducted by your insurer.
It is important to remember that after surrendering a policy, your original life insurance will no longer exist. You would receive the cash value less any fees that you owed, but you would have no death benefit coverage. For this reason, cash value surrender is often a last-resort option and only recommended if you have adequate life insurance coverage elsewhere or no longer need a policy in place.
An extended term insurance nonforfeiture option would allow you to purchase term life insurance with a death benefit equal to that of the original whole life policy. The new policy would be purchased with the cash value you had built in your old life insurance plan. The length of the new extended term coverage would be equal to the number of years that you paid premiums.
For example, say you bought a whole life insurance policy at 25 and paid premiums until you were 55, at which point you wanted to forfeit the policy. If you chose the extended term nonforfeiture, then your accumulated cash value would purchase an extended term insurance policy with a term of 30 years and death benefit equal to the original insurance plan.
Who is reduced paid-up insurance best for?
Reduced paid-up insurance is best for someone that may be experiencing financial hardship and cannot continue to make premium payments for their current policy.
In this case, instead of having the policy terminated due to lack of payments, you could convert to reduced paid-up insurance that requires no future premiums and gives you a guaranteed death benefit.
Similarly, if you wish to stop paying premiums but do not want to choose the cash value surrender option because you would incur a taxable gain (occurs when "total premiums paid" is less than the "total cash value"), then converting to reduced paid-up could be a smart option. You would be able to avoid any tax implications while still having death benefit coverage for your dependents that would be tax-free if you passed away.
We recommend you have sufficient life insurance coverage to meet your financial needs and provide support for your loved ones in the event that you pass away. Reevaluating your financial situation after major life events is crucial so that you are accurately covered.
For example, say you initially purchased enough life insurance to cover any expenses for sending your kids to college, but they are now employed and the policy has generated plenty of cash value to support and provide for your spouse in the event you pass away. In this scenario, you may choose to utilize a reduced paid-up option allowing you to stop premium payments but still have coverage for your spouse.
Who should not choose a reduced paid-up option?
If you currently depend on policy riders, then reduced paid-up insurance may not be the best choice. Typically, when converting to this type of policy, any riders that your original life insurance had would be eliminated. This is a critical factor to consider, as one of your policy riders may provide you with additional benefits that are vital to your life.
For instance, you may value your guaranteed insurability rider, which gives you the ability to purchase additional death benefit coverage without having to demonstrate your health through a medical exam. If you converted to a reduced paid-up policy, then you would lose the guaranteed insurability rider.
Summary of coverage
At the end of the year, your life insurance provider typically provides a letter or envelope with details about your coverage. In this package, your provider typically includes a chart that outlines how much your whole life policy would be worth if you decided to pay up for a reduced policy. This information can be useful for your financial planning needs and should be your first point of reference if you are thinking about nonforfeiture options like reduced paid-up insurance.
The three nonforfeiture options can easily be remembered with the acronym C-E-R and they are as follows:
1 – Cash Surrender – If the owner of the policy selects this nonforfeiture option, the policy will be canceled and the insurer will mail a check to the policy owner. If the policy owner elects cash surrender there will be no further life insurance coverage, and they may have to pay ordinary income tax if they receive more money than they paid into the policy in premiums.
2 – Extended Term – If this option is selected by the policy owner, the cash value from their original policy will be used to purchase a term policy that will have the same face amount (amount of insurance protection) as the original policy. If this option is selected, there is no additional premium due from the owner of the policy and they will have the same amount of coverage as they had in the original policy, but only for a limited time. Remember, term insurance is temporary. Term life insurance is NOT permanent.
3 – Reduced Paid-up – If this nonforfeiture option is selected by the policy owner, the cash value from their original policy is used as a single premium to purchase them a paid-up whole life policy. There are two things you need to know about this selection for your licensing exam. First, the amount of coverage under this new policy is reduced. Second, this new whole life policy will provide permanent coverage.
What is a nonforfeiture values policy?
Any policy which accumulates cash value is a nonforfeiture values policy. In fact, the cash values in a policy are sometimes referred to as nonforfeiture values. You need to know which policies will accumulate a cash value. Term insurance has NO cash value. In turn, term insurance has no nonforfeiture values.
However, policies such as whole life and endowments do accumulate cash value, which means they both have nonforfeiture values. Usually, the cash value will begin to accumulate in a policy after the first three years, however, single premium policies will have an immediate cash value.
Which nonforfeiture options continue to build up cash value?
If a policy owner elects the reduced paid-up nonforfeiture option, the cash value from their original policy will be used to purchase a single premium whole life policy. Whole life insurance is permanent and accumulates cash value. Remember, term insurance has no cash value, so if the owner selects the extended term option, there will be no further cash value accumulation. Of course, if they select cash surrender, there is no further life insurance coverage at all.
Which nonforfeiture option provides the highest amount of insurance protection?
Well, think of it this way. Say you have $50,000 that you would like to use to buy a life insurance policy. Between a whole life and a term policy, which policy would be able to provide you the biggest bang for your buck? Or, in other words, which policy would provide the highest amount of life insurance protection? Term!! Term insurance has no cash value and is the cheapest form of life insurance.
Which nonforfeiture option provides the highest amount of protection? Extended Term! Why? It’s the cheapest form of life insurance and accumulates no cash value!
Why is a nonforfeiture option used?
In most states, those life insurance policies that accumulate cash value are required to have nonforfeiture values. What if the owner of the policy forgets to pay their premium and the policy lapses? Can the insurance company just keep the cash value? No! They are generally required by law to provide the owner of the policy a choice of what they would like to do with their cash value. This is where the nonforfeiture values come in!
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