Cash value life insurance is life insurance that has a built-in savings account, separate from the death benefit. Life insurance types with cash value include universal and whole life insurance. A cash value life insurance policy is more expensive than term life insurance, which does not include this feature.
The cash value of life insurance is available to the policyholder to use while they're still alive, unlike the death benefit, which is only available to the beneficiary when the insured passes away. There are several ways to use life insurance cash value, such as loan collateral, paying premiums or surrendering the policy.
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Cash value life insurance is a permanent policy that earns money.
Whole life and universal life are two types of life insurance that earn cash value.
Term life insurance does not earn cash value or have this feature available.
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What Is Cash Value Life Insurance?
Cash value life insurance is a type of permanent life insurance that earns money and provides a death benefit to a beneficiary. The cash value investment feature of a permanent policy also earns interest.
Universal life and whole life insurance are types of life insurance that have cash value. This component makes permanent life insurance more expensive than term life insurance, which doesn’t earn cash value.
The policyholder can borrow against or withdraw the balance of the cash value account in an emergency. There are other types of life insurance policies that build cash value and there are various ways to use it, depending on the policy details.
Types of Life Insurance Policies That Include a Cash Value
Whole Life Insurance
This is the simplest type of permanent life insurance. The cash value of a whole life insurance policy earns interest at a fixed rate determined by the insurance company and defined prior to purchasing the whole life policy.
Guaranteed Acceptance Life Insurance
This is a type of whole life insurance that also earns cash value interest at a fixed rate. Its premiums and cost are higher, which leaves a smaller portion of the premium to be set aside for the cash value account.
Simplified Issue Life Insurance
This form of whole life insurance features fixed-rate growth for the cash value account. This policy may grow cash value faster than a guaranteed issue but not as fast as a whole life insurance policy.
Universal Life Insurance
Universal life insurance cash value has a minimum guaranteed growth rate but also aligns with market rates and the insurance company’s financial performance. The interest rate floor allows the cash value to grow at a predictable rate, even if the carrier or investment growth is poor.
Variable Universal Life Insurance
Variable universal life insurance allows policyholders to accelerate their cash value growth potential by investing in sub-accounts like bonds, mutual funds or stocks. Growth is based on investment performance and the cash value can experience negative growth if market performance is down.
Indexed Universal Life Insurance
Similar to variable life insurance, indexed universal life insurance uses a stock market index to determine cash value growth. Performance is tied to the market index of the policyholder’s choosing, such as the S&P 500 or the Dow Jones Industrial Average.
As the simplest type of permanent life insurance with a predictable cash value growth rate, whole life insurance is a great way to get familiar with cash value life insurance. Consider these six whole life insurance companies when choosing a cash value whole life insurance policy.
How Does Cash Value Life Insurance Work?
Cash value life insurance works as a savings and investment vehicle inside the life insurance policy. Part of the premium goes into the cash value account, which can grow over time. The insured can access this benefit during their lifetime to use in various ways. If any value remains when the insured dies, the rest goes back to the insurance company.
Buy a cash value life insurance policy
The first step to getting cash value life insurance is buying a policy. You should determine your life insurance needs and your goals for the cash value to help you decide which cash value life insurance policy is right for you.
Pay your premiums to build up cash value
Every time you pay a premium, it is divided between the cost of insurance and the cash value account. In the early years of your policy, more of the premium is allocated toward the cash value. The older you are, the more expensive insurance becomes, which reduces the cash value accumulation of each premium payment.
Accumulate cash value
It can take several years of accumulation before the cash value account builds up enough for you to access it. During this time, the value of the account can grow, either at a fixed or variable rate, depending on the policy type and investment method. The cash value for whole and universal life insurance grows at a fixed rate, while indexed and variable universal life insurance grows at variable rates.
Use the cash value
Once the cash value has grown to a point you can access it, it’s available to use as a living benefit. There are several ways to use the life insurance cash value, including:
- Making partial withdrawals
- Taking out a loan
- Withdrawing the cash value and surrendering the policy
- Using the cash value for paid-up additions or buying more life insurance
- Using the cash value to pay policy premiums
Understand how using the cash value could affect your policy
Using the cash value of your policy may have the following effects on your policy:
- If you make a partial withdrawal and don’t repay it, the unpaid amount will reduce the death benefit paid to your beneficiary.
- If you borrow against the cash value, expect to pay it back with interest or lower the death benefit amount.
- Withdrawing the entire cash value amount will cancel the policy and leave you without life insurance coverage.
- Using the cash value to buy more life insurance or pay premiums can free up money elsewhere but will reduce or eliminate the cash value growth.
If you decide to cancel or surrender your cash value life insurance, fees are assessed. The cash surrender value, the cash value minus the surrender fees, is what you will receive if you withdraw the entire cash value balance.
Benefits of Building Cash Value on Your Life Insurance Policy
Building cash value on your life insurance policy provides a living benefit that can be used if the need arises. This nest egg can be a valuable asset down the road. There are several ways to use life insurance cash value.
Make a Withdrawal
The amount you withdraw from the cash value is generally tax-free unless the amount is greater than the premiums paid into the policy. Making a withdrawal without paying it back will reduce the death benefit.
You can use the cash value to fund large expenses, such as:
- A child’s college expenses
- Supplemental retirement income
- A down payment for a house
- Emergency funds
Take Out a Loan
Another option is to take out a loan from the cash value account. Interest accumulates when you take out a loan, but the interest rate can be more favorable than rates offered by a bank. If you don’t repay the loan and interest before you die, the outstanding balance will reduce the death benefit amount your beneficiary receives.
Buy More Life Insurance
If you buy whole life insurance from a mutual insurance company, you might earn dividends at the end of the year. These dividends can buy more permanent life insurance, called paid-up additions (PUA). The policies are paid in full and eligible to earn dividends and cash value.
The policy might also include a rider for paid-up additions. The PUA rider comes with an extra cost, which is allocated to buy more paid-in-full whole life insurance. In later years, the paid-up additions can pay premiums or surrender the policy.
Surrender the Policy
If you decide down the road that you no longer need the life insurance policy, you can surrender it. The insurance company usually assesses surrender fees in the first decade or two of the policy. If you surrender the policy, you’ll receive the life insurance net cash value, which is the cash value amount minus any surrender fees and outstanding loan balances. The policy is then canceled, and you no longer have life insurance coverage.
Once a sufficient amount of cash value has accumulated, you can use the cash value to pay your premium. This can free up cash in your budget without sacrificing the death benefit coverage. However, you’ll need to keep a close eye on the policy, as draining the cash value can cause it to lapse.
Pros and Cons of Cash Value Life Insurance
While there are some advantages to consider, there are also disadvantages of cash value life insurance. Weighing the pros and cons can help you decide which type of policy is best for you.
Pros of Cash Value Life Insurance
Cash value life insurance offers a blend of life insurance protection and investment opportunities. Here are some of the key advantages:
- Lifetime Coverage: Unlike term life insurance, cash value life insurance provides coverage for the insured's entire life. This lifelong protection ensures that beneficiaries receive a death benefit regardless of when the insured passes away.
- Cash Value Accumulation: The policy's cash value grows over time, often at a guaranteed minimum rate. You can use this accumulation for various financial needs, such as retirement planning or emergencies, providing additional financial flexibility.
- Potential for Dividends: Some cash value life insurance policies, particularly whole life, may pay dividends. You can take the dividends as cash or use them to purchase additional coverage or reduce premiums.
- Tax Advantages: The growth of the cash value is tax-deferred, and loans against the cash value are generally tax-free. These tax benefits can enhance the policy's overall financial value.
Cons of Cash Value Life Insurance
While cash value life insurance offers several benefits, it's also important to understand the potential drawbacks. Here are some of the key disadvantages:
- Higher Premiums: Cash value life insurance premiums are typically higher than term life insurance premiums. The added cost reflects the investment component and lifelong coverage, which may not be necessary for all individuals.
- Potential Tax Liabilities: If not managed properly, actions like withdrawing more than the premiums paid or surrendering the policy can lead to tax liabilities. Proper understanding and management are essential to avoid unexpected taxes.
- Limited Investment Options: Depending on the policy type, investment options for the cash value may be limited. This restriction can hinder the potential for higher returns, particularly in favorable market conditions.
- Risk of Policy Lapse: If the policyholder fails to pay premiums or mismanages loans against the cash value, the policy may lapse.
Although term life insurance doesn’t have a cash value component, it is still up to 20 times cheaper than permanent cash value life insurance. Most people would be better off buying term life insurance and investing the difference themselves.
Working with a knowledgeable financial advisor can help improve your investment success compared to cash value on whole life insurance.
Should You Get a Cash Value Life Insurance Policy?
A cash value life insurance policy is best for someone who has already maxed out other tax-advantaged savings vehicles, such as a 401(k) or IRA. It can also be good for those with permanent life insurance needs, like paying for end-of-life expenses or someone with a dependent special needs child.
For most, term life insurance is sufficient if you’re solely looking for an affordable death benefit, with other options for investment savings.
You Want Lifetime Coverage
One thing term life insurance can’t offer is lifetime coverage. Cash value life insurance can provide a guaranteed death benefit, no matter how long you live. If you buy term life, it only lasts for a certain number of years. Once it expires, you no longer have coverage. As long as you continue to pay your premiums, whether through cash or accessing the cash value, permanent life insurance will stay in force, providing a guaranteed death benefit to your beneficiary.
You Want to Supplement Retirement Income
If you buy a permanent life policy when you’re young and continue to fund it, the cash value can grow exponentially. You can then withdraw some of the cash value to supplement retirement income or use it to pay the premiums so you still have “free” lifetime coverage.
You Want to Use It as Part of an Estate Planning Strategy
High-income earners often use permanent life insurance as part of an effective estate planning strategy. The policy is federally tax-free and is not part of the estate when a person dies. Beneficiaries can also use death benefit proceeds to pay estate taxes, greatly reducing or eliminating out-of-pocket costs when a loved one passes away.
You're a Business Owner
Business co-owners can fund a buy-sell agreement using life insurance, which covers each owner if the other dies. A business can also buy insurance on a key person in their business, which could be a founder, owner or key employee. The business is listed as the beneficiary, so the death benefit proceeds of a keyman policy can be used to hire and train a replacement, pay off debts or continue operations.
You Can Sell the Policy
If you no longer need the life insurance policy, but don’t want to surrender it, you could sell it. Life insurance settlement companies or brokers can facilitate the sale, taking a fee to help you offload the policy. This is often a complex solution and could end up costing more than surrendering the policy and paying fees assessed by the insurance company.
Choosing the right life insurance policy depends on your current and future needs. MoneyGeek has reviewed the best term and permanent life insurance companies to help you make the right decision.
Compare Life Insurance Rates
Ensure you are getting the best rate for your insurance. Compare quotes from the top insurance companies.
Frequently Asked Questions
Life insurance with cash value is great for some but isn’t for everyone. Here are the answers to some of the most common questions about cash value life insurance.
About Mark Fitzpatrick