What Is Cash Value Life Insurance?
Cash value life insurance is a form of permanent life insurance—lasting for the lifetime of the holder—that features a cash value savings component. The policyholder can use the cash value for many purposes, such as a source of loans or cash or to pay policy premiums.
- Permanent life insurance policies like whole life or universal life can accumulate cash value over time.
- Cash value life insurance is more expensive than term life insurance.
- Unlike term life insurance, cash value insurance policies don't expire after a specific number of years.
- Policyholders may borrow against a cash value life insurance policy.
- They may also withdraw cash from the policy, but this will also tend to reduce the death benefit.
Cash-Value Life Insurance
How Cash Value Life Insurance Works
Cash value insurance is permanent life insurance because it provides coverage for the policyholder’s life. Traditionally, cash value life insurance has higher premiums than term life insurance because of the cash value element. Most cash value life insurance policies require a fixed-level premium payment, of which a portion is allocated to the cost of insurance and the remaining deposited into a cash value account.
The cash value of life insurance earns a modest rate of interest, with taxes deferred on the accumulated earnings. Thus, the cash value of life insurance will increase over time. As the life insurance cash value increases, the insurance company’s risk decreases, because the accumulated cash value offsets part of the insurer’s liability.
Example of Cash Value Life Insurance
Consider a policy with a $25,000 death benefit. The policy has no outstanding loans or prior cash withdrawals and an accumulated cash value of $5,000. Upon the death of the policyholder, the insurance company pays the full death benefit of $25,000. Money collected into the cash value is now the property of the insurer.
Because the cash value is $5,000, the real liability cost to the life insurance company is $20,000 ($25,000 – $5,000).
Advantages and Disadvantages of Cash Value Life Insurance
The cash value component serves as a living benefit for policyholders from which they may draw funds. The life insurance net cash value is what the policyholder or their beneficiary has left over once the insurance company deducts its fees or any expenses incurred during the ownership of the policy. There are several options for accessing funds. For most policies, partial surrenders or withdrawals are permissible but these can reduce the death benefit.
Taxes are deferred on earnings until withdrawn from the policy and distributed. Once distributed, earnings are taxable at the policyholder’s standard tax rate. Some policies allow for unlimited withdrawals, while others restrict how many draws can be taken during a term or calendar year. Some policies limit the amounts available for removal (e.g., a minimum of $500).
Most cash value life insurance arrangements allow for loans from the cash value. Much as with any other loan, the issuer will charge interest on the outstanding principal. The outstanding loan amount will reduce the death benefit dollar for dollar in the event of the death of the policyholder before the full repayment of the loan. Some insurers require the repayment of loan interest, and, if unpaid, they may deduct the interest from the remaining cash value.
Cash value may also be used to pay policy premiums. If there is a sufficient amount, a policyholder can stop paying premiums out of pocket and have the cash value account cover the payment
Cash Value Life Insurance
Can borrow against the cash value
Can withdraw from the cash value in a tax-advantaged way
Permanent life insurance
More expensive out-of-pocket premiums
Withdrawals reduce death benefit
Unpaid policy loans and interest deducted from death benefit
Why consider cash value life insurance?
Policyholders of permanent life insurance have the ability to borrow against the accumulated value, which comes from regular premium payments along with interest and dividends credited to the policy.
Should I look into buying a cash value life insurance policy?
Those looking to build a nest egg over a time horizon of several decades may want to consider cash value life insurance as a savings option, alongside a retirement plan like an IRA or 401(k). Be aware that cash values often don't begin accruing until two to five years have passed.
What about those high premiums?
Yes, cash value policy premiums are typically higher than regular life insurance, because part of your payment goes toward savings.
What happens when you withdraw cash from life insurance?
If you make a withdrawal from the cash value in a life insurance policy, the death benefit will decrease. If you withdraw everything, the policy terminates. Withdrawing money from life insurance is tax-advantaged in that the IRS considered your withdrawals a return of the premiums you paid for the policy. So you can withdraw that amount of money without paying taxes. Any gains from dividends, however, would be taxed - but these would not occur until you've withdrawn all your premium payments.