Reduced Paid Up Insurance [Benefits and 5 Alternatives]

Reduced Paid Up Insurance (RPU), provides a strategic option for dividend paying whole life insurance policyholders seeking to maintain lifelong coverage without the burden of ongoing premiums. This article delves into the nuances of RPU, highlighting how it offers a lifeline to those facing financial shifts or reevaluating their insurance needs. By converting accrued cash value into a fully paid-up life insurance policy with a reduced death benefit, RPU ensures continued protection, tax-efficient wealth transfer, and the preservation of estate value.

Table of Contents

• Key Takeaways
• Reduced Paid Up Life Insurance
• How the Reduced Paid-Up Non-Forfeiture Option Works
• Electing a Reduced Paid-Up Non-Forfeiture Option
• Cash Value = Death Benefit
• Who Should Consider Reduced Paid Up Life Insurance?
• Drawbacks of Reduced Paid Up Insurance
• Alternatives to Reduced Paid-Up Life Insurance

Reduced Paid Up Life Insurance

Reduced paid up insurance is an optional contractual feature in whole life insurance policies that allows you to stop paying premiums and still keep a portion of your coverage for life. It works by using the cash value you’ve built up over time in your policy to buy a smaller, fully paid-up insurance policy. This means you won’t have to pay any more premiums, but you’ll still have life insurance coverage, just with a lower death benefit amount. Almost every whole life insurance policy includes a “reduced paid-up non-forfeiture option.”

What you are doing is decreasing a policy’s death benefit to a level where, based on the premium payments to date, the policy would have been paid-up, creating a reduced paid-up whole life insurance policy.

How the Reduced Paid-Up Non-Forfeiture Option Works

To get a better understanding of a reduced paid up policy, let’s break down the concept to its component parts.

• “Reduced” – When you exercise a reduced paid up policy option, you are reducing the policy’s death benefit in exchange for removing any obligation to pay further premiums;
• “Paid-Up” – The whole life policy is now effectively paid-in-full; the cash value that is traded in constitutes a single, lump-sum premium payment sufficient to keep the whole life policy in place for the rest of your life;
• “Non-Forfeiture” – The reduced paid up life insurance policy cannot be forfeited or lapse in the future because all premiums have been paid in advance;
• “Option” – reduced paid up is an option because it’s something you can but are not required to do; there are certain eligibility criteria, but once you meet them, you have a contractual right to elect the RPU option.

Reduced Paid Up Insurance Example

An example of how it works would be an Tom who has a $850,000 whole life insurance policy he purchased eight years ago that has accrued cash value of $100,000. Based on factors, such as his age and the total cash value account balance, the insurance company provides an offer to Tom for a fully paid-up whole life insurance policy. In this example, the cash value of $100,000 was able to purchase a $250,000 death benefit. The policy’s guaranteed death benefit is now reduced to the new amount and no more premiums are due. And Tom’s now paid up insurance policy still earns interest and potential dividends going forward.

Electing a Reduced Paid-Up Non-Forfeiture Option

The precise eligibility criteria and requirements to activate an RPU option vary between policies and insurance companies. With any whole life policy, before the option can be elected, the policy must have been in place for a minimum period and/or have received a minimum aggregate sum of premiums.

Typically, if you want a reduced paid up insurance policy then three years is typically the required minimum period, but some policies require longer, and if you have made additional premium payments, an insurance company might allow you to make the election earlier.

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Cash Value = Death Benefit

When you opt for RPU, the new death benefit will be at least equal to the current cash value. The insurance company uses multiple factors to make the precise calculation, including how long the policy has been in place, the total premiums paid, the current cash value, and your age.

Generally, a policy that has been in place longer will have accrued a higher cash value and therefore receive a higher death benefit.

Likewise, any prior premium over-payments raise the cash value, leading to a higher adjusted death benefit.

All things being equal, a younger policyholder will receive a higher reduced paid up insurance death benefit because the insurer anticipates having more time to invest the premium before paying out the death benefit.

Take Note

Importantly, after an reduced paid-up option is exercised, the policy still has cash value.  So, you can still take loans against the policy or surrender it for cash or an annuity – should you so choose.  And, the reduced paid up insurance policy is still a whole life policy, so it will continue to earn interest and may receive life insurance dividends even though no further premium payments are made.

Who Should Consider Reduced Paid Up Life Insurance?

An RPU option can be beneficial for individuals who want or need some life insurance but whose situation has changed – such as recent retirees – so that it no longer makes sense to pay premiums and maintain the current level of coverage.

Or someone who wants to retain a death benefit but can no longer afford monthly premiums can prevent a policy from lapsing by exercising an RPU option.

From a tax-savings standpoint, an RPU election can be advantageous for an insured looking to avoid the income tax hit involved in cashing out a policy that has substantially appreciated.

Because a life insurance pay-out is not taxable income and policy proceeds can easily be kept out of a taxable estate, a reduced paid up insurance policy minimizes tax consequences while still avoiding further premiums or a policy lapse.

Example

As an example, let’s say you have a policy with a $100,000 death benefit, an accrued cash value of $35,000, and you have thus far paid aggregate premiums of $25,000.  You’re getting ready to retire, the kids are self-sufficient, and you no longer need $100,000 in life insurance coverage.

If you surrender the policy, the $10,000 in cash value growth will be taxable income. But, if you elect reduced paid up life insurance, the policy will convert to a death benefit of at least $35,000, payable upon your death to your named beneficiary tax-free.

Moving forward, the reduced paid up insurance policy will continue to grow thanks in part to guaranteed interest and potential dividend payments, but you’ll never have to make another premium payment. And, if you ever need ready liquidity, you can always take out a loan or surrender the policy for the cash value.

Drawbacks of Reduced Paid Up Insurance

Reduced Death Benefit

The obvious drawback to an RPU election is that the policy’s death benefit is reduced. So, if you’re still relying on the full amount of the benefit to provide for your loved ones, fund a trust, or pay estate expenses, you probably shouldn’t make an RPU election.

But if you have reached a point where you don’t need as much or any life insurance, reduced paid up insurance can make sense. If your other assets will be sufficient to take care of any dependents, electing RPU to halt premium payments and free up funds in your budget can be a good financial move.

Irrevocable

Reduced paid up insurance elections are irrevocable.  Some states and policies allow for reinstatement within a certain amount of time, usually requiring the policyholder to catch up on premiums.

But, in most cases, once a policy is converted to RPU, there’s no going back, so you are relieved of the obligation to pay future premiums, but you cannot choose to pay additional premiums either.

May Lose Riders

Another consideration is that paid up insurance coverage provided after an RPU election is usually more stripped down than prior to the election, in life insurance riders may not survive the transition. So, if you’re counting on a rider that triggers coverage in the event of a terminal illness or severe injury, for example, an RPU election might not be a good idea.

Paid-Up Additions

The right to purchase paid-up additions is offered through policy riders that usually require a higher starting premium. It is often described as buying paid up miniature life insurance policies that act as a supplement to a primary whole life insurance policy. The mini-policies are purchased in full using dividends and require no additional premiums (hence ‘paid-up addition’).  Once a paid-up addition is purchased, its death benefit is guaranteed for life.

In many cases, paid-up additions can still be purchased after an RPU election – provided the rider was included with the original policy and survives the election. As a result of the decreased death benefit following an RPU election, the dividend amount (and therefore the paid-up addition’s death benefit) usually decreases, at least for a while.

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Alternatives to Reduced Paid Up Life Insurance

A reduced paid up policy is a great option to have available but before you make the decision to exercise your contractual right, consider some alternatives.

Premium offset

Premium offset is a whole life strategy under which a policyholder applies the policy’s dividends, growth, and any previous additional premium payments toward future premiums.

Premium offset maintains the policy’s death benefit but limits future growth because some or all of the growth is applied toward underwriting costs (i.e., premiums) rather than cash value.

Unless the policyholder has pursued overfunded life insurance and made substantial premium over-payments, a policy will have to have been in place for many years before dividends and growth are sufficient to sustain it.

Premium offset differs from reduced paid up insurance in that the former can be elected temporarily. So, for example, a policyholder can choose to offset premiums with dividends and growth for a year or two and then resume payments if warranted by market conditions or personal financial circumstances.

Surrender

“Surrendering” a whole life insurance policy basically means electing to forego the death benefit and instead receive the cash value in the form of a lump-sum check or annuitized payments from the insurance company.

For this reason, a policy’s cash value is also sometimes referred to as its “surrender value.”

Surrendering a whole life policy for cash makes sense in some situations, but cashing out is by no means the only option for taking advantage of cash value.

This is because cash value is not just a theoretical sum the insurer is willing to pay now to avoid a future obligation to pay the death benefit.

It is an actual financial asset – a separate account that grows with each premium payment and earns interest.

Life Insurance Loan

After a whole life policy has been in place long enough, the policy’s cash value can serve as collateral for a low-interest loan from the insurance company or certain banking institutions.

Cash-value loans, which are usually not included in credit reports, come with attractive terms because they are low-risk to the insurance company – if you don’t repay the loan before dying, the outstanding amount is simply deducted from the policy’s death benefit.

No More Premiums

Another underrated option for capitalizing on accrued cash value is to use it to secure life insurance coverage that doesn’t require any further premiums. One such option for anyone who has yet to purchase coverage is single premium life insurance, where you pay one lump sum payment. However, the negative to this option is that the policy loses some of the tax benefits since it is considered a modified endowment contract.

Extended Term Insurance

Another approach is to surrender a whole life insurance policy and apply the cash value as a lump-sum, upfront premium payment for an extended term insurance policy that doesn’t require any further premiums for the duration of the policy. Depending on your age, health, and total premiums paid, this can end up being a good deal, but, of course, you no longer have permanent life insurance.  So, if you outlive the term, you won’t receive any pay-out.

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