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Cash Value Life Insurance – What It Is and How It Works

You need life insurance to pay for your final expenses, such as your funeral and burial. It can cover expected future obligations your survivors might not be able to afford on their own, such as your kids’ college education. Or it can pay down big debts that survive you, such as a jointly held mortgage.

All those uses for life insurance happen after you die. But if you have a cash value life insurance policy, your insurance coverage is also quite useful while you’re still alive. Depending on the specific type you have, you can borrow against your policy, make withdrawals from it, and even pay your premiums.

But before you do any of that, it’s crucial you understand how cash value works and all the fine print that comes with it.

What Is Cash Value Life Insurance?

Cash value life insurance accrues value you can use during life over time. As the policyholder, you can access this value before your death through loans and withdrawals or use it to pay your life insurance premium.

Almost all cash value life insurance policies are permanent life insurance policies. Though some expire when you reach a specific, very advanced age, most permanent life insurance policies have no fixed expiration date. They remain in effect as long as you continue paying premiums.

That’s a key distinction between permanent and term life insurance, which always has a fixed expiration date. 

Term life insurance policies rarely accrue cash value, either. That means permanent life insurance is the way to go if you want lifelong coverage that can pay you back in life, not just in death. 

How Does Cash Value Life Insurance Work?

When you pay into a cash value life insurance policy, your premium funds the death benefit and the cash value component. Early in the policy’s life, most of your premium goes toward cash value. As time goes on, more of the premium goes toward the death benefit. The death benefit is what the policy beneficiary receives if you die during the policy term.

That’s different from a typical term life policy. When you pay into a term life policy, your entire premium goes only toward your death benefit. 

Consistent Premiums

Most cash value life insurance policies have level premiums. That means your premium doesn’t change over time. It’s the same the first year as it is in the 30th, 40th, or 50th year. 

But because you’ll almost certainly die during your cash value policy’s term, that premium is much higher than the premium you’d pay on a similarly sized term life policy. Many policyholders outlive their term life policies, meaning their beneficiaries don’t get death benefits.

How Cash Value Accrues

Your policy’s cash value doesn’t appear right away. Depending on your policy’ terms, it doesn’t begin to accrue until several years have passed. Even after that, it won’t amount to much until later in the policy’s life. It grows faster after the 10th or 15th year and accrues steadily for many years afterward. 

Accessing Cash Value

Your cash value policy’s death benefit usually only unlocks when you die. In some cases, it may unlock when you get a terminal diagnosis. That allows you to receive a portion of it while you’re still alive.

You can only access your policy’s cash value component while you’re alive. Your beneficiaries can get the death benefit portion if they file a valid death claim, but the cash value disappears after you die.

Depending on the specific type of policy, you can access the cash value by:

  • Taking a loan against it
  • Requesting a partial withdrawal
  • Requesting a full withdrawal, also known as surrendering the policy
  • Requesting an increase to your death benefit without a premium hike
  • Using it to pay premiums

How Using Cash Value Affects the Death Benefit

Your policy’s cash value and death benefit are separate, but they interact. 

If you take a loan or withdraw from your policy’s cash value, the death benefit declines by a corresponding amount plus fees and interest. If you borrow against your policy, you can restore the death benefit by paying it back. 

You generally can’t pay back partial withdrawals. If you want to make a full withdrawal of the cash value, you have to surrender the policy. That cancels the policy, meaning your beneficiaries get nothing from the insurer when you die.

What Can You Do With the Cash Value?

Every cash value life insurance policy allows you to tap the cash value while you’re still alive. Your options depend on the specific type of policy and how long the policy has been in effect, among other factors.

Make Partial Withdrawals

Some cash value life insurance policies allow partial withdrawals from the cash value balance. 

Whole life insurance policies are notable exceptions. They generally don’t allow partial withdrawals.

A partial withdrawal is tax-free as long as it doesn’t exceed the current cash value. If it does and the insurer permits it, the excess amount could be taxable as income.

Take Out Loans

You can borrow against your policy’s cash value at a predetermined interest rate, typically between 5% and 10%. That rate is usually higher than the rate of growth on the cash value, and it can fluctuate with benchmark interest rates. If you don’t pay back the loan before you die, your death benefit falls by the combined loan amount and accrued interest.

Like partial withdrawals, cash value loans are tax-free. They generally can’t exceed the cash value balance, so you don’t have to worry about triggering a tax penalty.

Withdraw All the Cash (Surrender the Policy)

If you decide you no longer need life insurance or need to access the entire cash value in a financial emergency, you can surrender your policy. That cancels the policy, which means you no longer have to pay premiums and your beneficiaries won’t receive a death benefit.

When you surrender your life insurance policy, you receive the cash value and any accrued interest, minus:

  • Surrender fees, which are highest during the first years of the policy and gradually phase out over seven to 10 years 
  • Unpaid loan balances
  • Interest on unpaid loan balances
  • Unpaid premiums

Apply It to Premium Payments

Later in your policy’s life, you can put its cash value toward premium payments. Each premium paid out of cash value reduces the cash value by a corresponding amount.

Be careful with this option. If you use the entire cash value to pay premiums and don’t switch back to paying cash premiums, your policy could lapse due to nonpayment.

Types of Cash Value-Building Life Insurance Policies 

Virtually all cash value life insurance policies are permanent. Term life insurance policies seldom build cash value.

Cash value life insurance policies come in four main varieties: whole life, universal life, variable universal life, and indexed universal life.

Whole Life Insurance

Whole life insurance policies’ cash value component grows at a predictable rate. This rate can remain fixed or fluctuate, but it always remains at or above a minimum guaranteed level. Premiums typically remain fixed for the life of the policy as well.

With whole life, you don’t have any control over how the insurance company invests your premiums. You just watch your cash value balance grow. However, due to its predictability and guaranteed returns, whole life insurance is usually more expensive than other types of cash value life insurance.

Guaranteed Universal Life Insurance

Like whole life insurance, guaranteed universal life insurance promises fixed premiums and predictable cash value accumulation. However, guaranteed policies’ cash value components grow slower than those of whole life policies, meaning it can take decades to build a significant nest egg. The upside to slow growth is affordable premiums — guaranteed universal life is much cheaper than whole life.

Variable Universal Life Insurance

Variable universal life insurance gives you more control over your cash value investments, so you have more control over how it grows. You can designate a portion of your cash value to any number of subaccounts holding different mixes of marketable securities like stocks and bonds. 

Investing in market-traded securities raises your cash value’s upside when the market does well but increases risk when the market fares poorly. You can typically manage your risk by raising or lowering your death benefit, though there are limits to how you can do that described in your policy. Changes to your death benefit can raise or lower your premium.

Indexed Universal  Life Insurance

Indexed universal life insurance attaches your cash value to an underlying index, such as the S&P 500 stock index. Its value rises and falls with the index’s price, which increases both upside and risk. Like variable universal life, you can typically adjust your indexed universal life premiums and death benefits within certain limits.

Pros & Cons of Cash Value Life Insurance

Is cash value life insurance right for you? To answer that question, you must consider the arguments for it and against it.

Pros of Cash Value Life Insurance

Cash value life insurance offers a source of financial flexibility as you age. While it’s not recognized as a good investment, its tax benefits and relative stability offer multiple advantages.

  • You Can Take Tax-Free Loans Against It. This is one of the biggest benefits of cash value life insurance. You have to pay interest on these loans, but they don’t require credit checks or income verification.
  • You May Be Able to Withdraw Some Cash Value Without Canceling Your Policy. Depending on the policy type, you may be eligible for a partial cash value withdrawal. This withdrawal is also likely tax-free, and unlike a loan, you don’t have to repay it.
  • You May Have Some Control Over Its Investment. Depending on the policy type, you have some (or a lot of) control over how you invest your cash value — and thus, how quickly it can grow.
  • You Can Use It to Pay Your Premiums. As your cash value grows, you can use it to pay your policy’s premiums. That’s useful if you’re living on a fixed income in retirement.

Cons of Cash Value Life Insurance

It’s essential to have a trusted insurance agent or financial advisor to help you make sense of your policy. Cash value life insurance is complicated and has some fairly serious drawbacks. 

  • Premiums Can Be Steep. Cash value life insurance is much more expensive than term life insurance. If you’re mainly concerned with leaving your survivors something after you die, term life is a better deal.
  • It Takes Years to Build. Cash value grows very slowly during a policy’s early years. Don’t expect to be able to use it for anything substantial for a decade or longer.
  • It’s Usually Not a Good Investment. Due to potential fees, charges, and limitations on how you can invest your money, cash value life insurance is not a good investment. Its long-term returns tend to be lower than diversified stock market investments.
  • Loans and Withdrawals Can Eat Into Your Death Benefit (or Wipe It Out). It’s nice to be able to borrow against your policy’s cash value or partially withdraw it. But if you don’t make the insurance company whole, your death benefit will drop accordingly.
  • Draining Your Cash Value Can Lapse Your Policy. If you burn through your policy’s cash value because you used it all to pay premiums, your policy could lapse if you don’t revert to cash payments.

Should You Get a Cash Value Life Insurance Policy?

As an investment, cash value life insurance underperforms the major stock market averages over long periods. Fees, interest on loans, and delayed accrual all eat into cash value’s growth.

If your primary goal is to maximize your return on investment, you’re better off combining a term life insurance policy with a diversified portfolio held in a mix of tax-advantaged and taxable brokerage accounts. Your money is likely to grow faster that way, and you’ll lose much less of it to life insurance premiums.

However, cash value life insurance can be useful. It diversifies your net worth away from owner-occupied real estate, stocks, and bonds. Over time, it becomes a flexible source of borrowing power — an alternative or complement to real estate equity and stock portfolio loans.

Cash Value Life Insurance FAQs

Cash value life insurance is confusing, no question about it. While the details vary from insurer to insurer and policy type to policy type, the answers to these questions should prove useful as you evaluate your options and decide whether a cash value policy makes sense for you.

How Long Does It Take for Life Insurance to Build Cash Value?

Cash value is minimal during the first two to five years of a life insurance policy, but how long it takes to see any cash value depends on the policy type. Whole life generally accrues cash value the fastest, while guaranteed universal life accrues the slowest. 

Do I Pay Taxes on Life Insurance Cash Value?

Usually not. Loans against cash value are tax-free because they can’t exceed the amount you paid into the policy plus accrued interest. Partial withdrawals of cash value are taxable only if they exceed the amount you paid plus interest, which your life insurer may or may not allow.

Surrendering your policy is more complicated. The amount you paid into the cash value isn’t taxable, but any gains on the cash value may be. Consult your policy documents, insurance agent, or tax advisor for guidance about your specific policy.

What Happens if I Don’t Pay Back a Life Insurance Loan?

If you don’t pay back a life insurance loan before you die, your death benefit drops by the amount of the unpaid loan balance plus any unpaid interest. 

For example, say you took out a $30,000 cash value loan at 8% interest. You die two years after taking out the loan without having paid any of it back. Your death benefit is $300,000. 

Your unpaid loan balance would be about $35,000. That means your beneficiaries would receive about $265,000 at your death — $300,000 minus $35,000. 

What Happens to Cash Value in a Whole or Universal Life Insurance Policy When I Die?

When you die, the cash value in your permanent life insurance policy goes back to the insurance company. In other words, while it’s yours to do with as you please while you’re alive, it’s not truly yours, and your beneficiaries aren’t entitled to it.

The best way to ensure you use your cash value without draining your death benefit is to pay your premiums with it later in the policy’s life. Just be sure to switch back to cash payments if necessary so your policy doesn’t lapse when the cash value account is empty.

What Is Cash Surrender Value?

Cash surrender value is the amount you receive when you surrender your policy. 

Your surrender value may be lower than the total cash value due to expenses like surrender charges and unpaid premiums. Surrender charges are highest during the first few years of the policy and gradually decline over time.

What Happens When a Policy Is Surrendered for Cash Value?

To surrender your life insurance policy, contact the person who helps you manage the policy. That’s most often an insurance agent, a financial advisor, or a representative of the insurance company itself. They can help you ensure the process goes smoothly.

First, you must fill out a surrender form and submit it to the insurance company. Keep a copy for your records. If the insurance company approves the surrender, it mails you a confirmation or communicates the news to your agent.

Within a few weeks, it sends a check for the surrender value — the cash value minus any deductions, such as surrender fees and unpaid premiums. Once you deposit the check into your bank account, you and the insurance company have no further obligation to one another.

Final Word

If you’re in the market for life insurance, decide early whether you want a term or permanent policy.

One powerful argument in favor of a permanent policy is the cash value component. Most permanent policies build cash value over the years, eventually adding up to a substantial nest egg you can borrow against, withdraw, or use to pay your premiums.

But cash value life insurance comes with drawbacks. It takes a long time to build your balance, and tapping your cash value early can incur hefty fees. Plus, unpaid cash value loans reduce your death benefit, shortchanging your survivors.

That’s not to say cash value life insurance is never the right call — only that it’s not as good a deal as it might first appear. 

Brian Martucci writes about credit cards, banking, insurance, travel, and more. When he's not investigating time- and money-saving strategies for Money Crashers readers, you can find him exploring his favorite trails or sampling a new cuisine. Reach him on Twitter @Brian_Martucci.

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