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 multiple purposes, such as borrowing or withdrawing cash, or even using it to pay policy premiums.
Key Takeaways
- Permanent life insurance policies like whole life and universal life can build cash value over time.
- Cash value life insurance is typically more expensive than term life insurance.
- Unlike term life insurance, cash value insurance policies do not expire after a set number of years.
- Policyholders can borrow against a cash value life insurance policy.
- Withdrawals from the policy are possible but will reduce the death benefit.
How Cash Value Life Insurance Works
Understanding How Cash Value Life Insurance Operates
Cash value insurance is a type of permanent life insurance because it provides coverage for the policyholder’s entire life. Typically, cash value life insurance has higher premiums compared to term life insurance due to the cash value aspect. A portion of each premium payment goes towards the insurance cost, while the rest accrues in a cash value account.
The cash value that accumulates in a life insurance policy earns interest, and taxes on these earnings are deferred. As premiums are paid and interest accrues, the cash value increases over time. This not only benefits the policyholder but also reduces the insurer’s liability, as the accumulated cash value offsets part of the company’s risk exposure.
A Real-World Example of Cash Value Life Insurance
Consider a policy offering a $25,000 death benefit with no outstanding loans or prior cash withdrawals and an accumulated cash value of $5,000. Upon the policyholder’s death, the insurance company pays the full $25,000 death benefit. The cash value becomes the insurer’s property, so the effective liability cost to the insurance company is $20,000 ($25,000 - $5,000).
Note
Whole life, variable life, and universal life insurance policies are all examples of cash value life insurance. Term life insurance, in contrast, does not accrue cash value.
Accessing the Cash Value in Life Insurance
The cash value component offers living benefits to policyholders, allowing them to access these funds. Here are several ways to do so:
Withdrawals
Partial withdrawals or surrenders may be permitted, although these choices reduce the policy’s death benefit. Some policies allow for unlimited withdrawals, while others limit the amounts withdrawable per term or calendar year. It’s important to note that amounts exceeding what has been paid into the cash value are taxed as ordinary income.
Policy Loans
Most cash value life insurance policies allow for policy loans against the cash value. Similar to other loans, the issuer charges interest on the outstanding principal. Failure to repay the loan amount reduces the policy’s death benefit by the outstanding loan amount at the policyholder’s death.
Premium Payments
The cash value can also be used to pay policy premiums. If the cash value is significant, the policyholder can stop paying premiums out of pocket, allowing the cash value account to handle the payments.
Why Opt for Cash Value Life Insurance?
Permanent life insurance holders have the advantage of borrowing against the accumulated cash value, derived from regular premium payments and any accrued interest and dividends.
Should You Consider Buying a Cash Value Life Insurance Policy?
Individuals planning to build a nest egg over several decades might view cash value life insurance as a viable savings option, in addition to retirement plans like IRAs or 401(k)s. However, be aware that cash values may not start accruing until two to five years have passed. Additionally, accessing the cash value may incur penalties if done prematurely.
Are Cash Value Policy Premiums High?
Yes, premiums for cash value policies are typically higher than regular life insurance premiums due to the savings component built into the premiums.
What Happens When You Withdraw Cash From a Life Insurance Policy?
When withdrawing from the cash value in a life insurance policy, the death benefit decreases. A total withdrawal terminates the policy. Additionally, withdrawing money is tax-advantaged as the IRS views it as a return of the paid premiums. Only gains from dividends or interest are taxable after all premiums have been withdrawn.
The Bottom Line
Cash value life insurance allows policyholders to accumulate funds for future use. A portion of each premium deposited into an interest-bearing account grows tax-free over time. This cash can be accessed for myriad purposes during the insured’s lifetime.
Related Terms: life insurance, term life insurance, whole life insurance, universal life insurance, policy loans, premium payments.
References
- Fidelity Life Insurance. “Cash Value Life Insurance”.
- Allstate. “What Is Cash Value Life Insurance?”
- California Department of Insurance. “Life Insurance Guide”.
- Prudential. “A Guide to Life Insurance Dividends Options”.
