A reduced paid up is a common and useful non-forfeiture option designed as an arrangement between the insurer and the insured when the insured wishes to stop paying premiums for their whole life policy or is no longer able to.
Whew. Let’s make this a bit simpler by taking a step back and starting at ground zero. Here’s life insurance policy 101:
Life Insurance Policies are arrangements between life insurance companies and their insured clients. Life Insurance Policies pay a benefit to the beneficiaries listed in the policy (children, spouses, relatives of the insured clients).
This benefit is paid after the person insured by the policy dies and is therefore called a death benefit.
There are three main types of life insurance policies:
- Term Insurance — This type of life insurance is paid for by the client for a set period, such as 10 or 20 years or more.
- Whole Life Insurance — This life insurance is designed to last through a person’s lifetime. This type of policy accumulates cash value within the policy and the annual premium is higher than for term policies.
- Universal Life Insurance — This life insurance is a hybrid of term and whole life. The premiums are flexible and they can accumulate cash value.
Almost every whole life policy includes a “reduced paid-up (RPU) non-forfeiture option.”
Reduced paid-up insurance essentially allows you to stop paying your life insurance premiums on your whole life policy.
You apply your accumulated cash value as a lump-sum premium payment toward a whole life policy and get a lower death benefit than with your current policy.
In exchange for no longer having to pay premiums, your life insurance company will give you a reduced amount of life insurance. That reduced amount is based on the cash value accumulated in your policy at the time you stop paying.
Let’s say you took out a whole life policy for $100,000. After 20 years of paying for the policy, you decide you’d like to stop paying for it.
In this situation, you have three options with your whole life policy:
You basically “give up” the policy and receive the cash value that’s accumulated over those 20 years. Here’s how it works:
If you have whole life insurance and no longer want to pay premiums for your policy for any reason, you can either opt to surrender it and receive the current cash value or use that same accumulated cash value to fund your reduced paid-up insurance coverage.
Cash value surrender is the most basic nonforfeiture option available. In this case, you forfeit your life insurance for the cash value that has built up in the policy.
Before receiving the cash value payment, any remaining policy loans or premiums owed will be deducted by your insurer.
“Surrendering” a whole life insurance policy basically means choosing to abandon the death benefit and receive the cash value instead — in the form of a lump-sum check or annuitized payments from the life insurance company.
For this reason, a policy’s cash value can also sometimes be referred to as “surrender value.”
Surrendering a whole life policy for cash makes sense in some situations, but cashing out is certainly not the only possible option for taking advantage of your cash value.
Concepts like infinite banking, for example, prove the diverse uses of your whole life policy. It can be used to finance your lifestyle in a way that a bank could, but with zero fees.
What’s important to take in here is that your policy’s cash value isn’t just a theoretical sum the insurance company is willing to pay you —
It is an actual financial asset — it grows in a separate account with each premium payment and earns you interest.
It’s also important to remember that after surrendering a policy, your original life insurance ceases to exist. You receive the cash value (minus any fees that you owe), but your heirs receive no death benefit coverage.
For this reason, cash value surrender is often considered a last-resort option and only recommended if you have life insurance coverage somewhere else, or if you no longer need this policy.
In the case of the extended term insurance option, you essentially convert your policy to term insurance and keep the full face amount of your policy ($100,000).
An extended term insurance nonforfeiture option allows you to purchase term life insurance with a death benefit equal to that of your original whole life policy.
The new policy is purchased with the cash value you have 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 had paid premiums —
If you paid premiums for 20 years on your previous policy, your new policy offers a 20-year term life insurance.
However, if you wish to keep your permanent life insurance and still avoid any further premiums, there’s a way to do that, too. We’re finally there:
Reduced Paid-Up Insurance is a non-forfeiture option available on whole life policies, which gives the policyowner the right to a fully paid-up policy (for some reduced amount of the guaranteed death benefit).
What you are essentially doing is decreasing your policy’s death benefit to a level where, based on your premium payments to date, your policy would have been paid up, creating a “reduced paid-up whole life insurance policy”.
To better understand this, let’s break down the term together:
Reduced Paid-up Nonforfeiture Option
“Reduced” — This means that when you choose an RPU option, you are reducing the policy’s death benefit in exchange for no more premiums.
“Paid-Up” — The policy is now effectively paid-in-full by using your cash value; with it, you pay a “lump-sum premium payment”; this is sufficient to keep your policy in place for the rest of your life.
“Non-Forfeiture” — The policy cannot be forfeited and can’t lapse in the future, because all premiums have been paid in advance.
“Option” – RPU is an option because it’s something you can but don’t have to do; there are some eligibility criteria, but when you meet them, you have a contractual right to choose the (RPU) option.
Remember those $100,000? Well, in this case, you receive a policy with a lower face value but it remains in force for the rest of your life. After 20 years, you might receive a $70,000 reduced paid-up policy
(This is just an example, and these amounts may differ between different companies)
With all three of these options, you no longer have to pay premiums. Your policy might even include a reduced paid-up illustration to clarify exactly how much you would receive.
An RPU option can be beneficial for individuals who want or need some life insurance but whose financial situation has changed (i.e. recent retirees) in a way that it no longer makes sense to pay premiums and keep the same coverage.
The RPU option is also useful for someone who wants to retain a death benefit but can no longer afford monthly premiums — to prevent the policy from lapsing.
Choosing an RPU can also be advantageous for you if you’re looking to avoid income tax when cashing out a policy.
Because a life insurance pay-out is not considered taxable income and policy proceeds can relatively easily be kept out of a taxable estate, choosing an RPU minimizes tax consequences, prevents your policy from lapsing, and stops any further premiums.
Reduced Paid-Up is NOT a Paid Up Addition (PUA) — though the terms have a similar ring to them.
Paid-up additions are often described as small life insurance policies that serve as a supplement to a bigger whole life policy.
These 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.
The right to purchase paid-up additions is offered through policy riders which usually require a higher starting premium.
As we’ve explained above, the reduced paid-up nonforfeiture option is one of several ways in which whole life policyholders can adapt their policies to the ever-changing life circumstances, market conditions, and financial situations.
A paid-up addition is added to a base whole life policy through extra premium payments, while the reduced paid-up insurance option is chosen when someone no longer wants to pay premiums and chooses to reduce their base policy.
After choosing the reduced paid-up non-forfeiture option (available on all whole life policies), your base policy then essentially takes the form of a paid-up addition.
In many cases, paid-up additions can still be purchased after you choose an RPU — given that the rider was included with the original policy and survives your RPU election.
This means that MANY paid up additions will be terminated if you choose the reduce paid up option.
Furthermore, 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.
For the sake of an example, let’s assume you have a policy with a $100,000 death benefit, an accrued cash value of $35,000, and that you have thus far paid aggregate premiums of $25,000.
You’re getting ready to retire, your kids are self-sufficient, and you no longer need $100,000 in life insurance coverage.
If you surrender the policy, the $10,000 in growth will be deemed taxable income.
However, if you elect reduced paid-up life insurance, the policy will convert to a death benefit of around $35,000 — payable to your beneficiary upon your death completely tax-free.
After this, your policy will continue to grow thanks to guaranteed interest and potential dividend payments, and YOU will never have to make another premium payment.
Plus, you can always take out a loan or surrender the policy for the cash value if you desire.
The obvious drawback to choosing an RPU is that the policy’s death benefit is reduced — and the size of this reduction will vary on multiple factors.
However, if you think your other assets will be sufficient to take care of your loved ones, choosing an RPU to halt premium payments and free up funds in your budget can be a good financial move.
Of course, there are other major things that need to be considered here.
Coverage provided after an RPU election is usually more stripped-down than in your policy, and many life insurance riders may not survive this transition.
If you’re counting on a rider that, for example, triggers coverage in the event of a terminal illness or severe injury, an RPU election might not be a good idea.
For the most part, reduced paid-up insurance elections are irrevocable.
Some states and policies allow for policy reinstatement within a certain amount of time, usually requiring the policyholder to catch up on their premiums.
However, in most cases, once a policy is converted to RPU, there’s no going back.
Not only are you relieved of the obligation to pay future premiums, but you CANNOT choose to pay additional premiums either. This means that you won’t be able to use the whole life policy’s guaranteed growth as a hedge against poor performance by other investments.
Reduced paid-up insurance allows 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.
This means that you probably shouldn’t opt for an RPU if you’re still relying on the full amount of the benefit to provide for your loved ones, fund a trust, or pay your heirs’ estate expenses.
If you have, on the other hand, reached a point where you don’t need as much (or any) life insurance, an RPU can make sense.
Before making an RPU election, it’s best to discuss the effects of this choice with an experienced life insurance advisor.
Carefully consider the pros and cons of choosing this option, to avoid any unwanted taxes and losing policy benefits.