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What is Cash Value Life Insurance?
By Ingrid Case MONEY RESEARCH COLLECTIVE
A life insurance policy protects the people who financially depend on you. If you suffer an untimely death, your policy will pay your beneficiaries a death benefit. That mean your loved ones will realize a payout to help them pay for their house, college tuition, retirement savings or other needs.
But life insurance companies also offer policies that accumulate monetary value you can use while you’re still alive. Cash value life insurance has a death benefit, like all life insurance. Yet it also offers an investment component from which you can borrow during your lifetime.
Here’s more about what these policies offer and how they work.
Table of contents
- What is cash value life insurance?
- How does cash value life insurance work?
- Pros and cons of cash value life insurance
- Which type of life insurance policy generates immediate cash value?
- How can you calculate the cash value of a life insurance policy?
- Is cash value life insurance worth it?
- Cash value life insurance FAQs
- Summary of our guide to cash value life insurance
What is cash value life insurance?
In order to understand cash value life insurance, it’s helpful to understand that life insurance coverage comes in two basic varieties: term life insurance, which covers you for a stated time period — perhaps twenty years — and permanent life insurance, which covers you for the rest of your life. Unlike term life insurance, permanent policies don’t expire after a certain number of years.
Cash value is a feature of some kinds of permanent life insurance policies. A policy’s cash value is the part of the product that is invested and earns interest. As the policy’s cash account grows in value over time, it can be available for you to withdraw or to borrow against. You can use also use it to pay the policy premiums.
Whole life insurance, universal life insurance, variable life insurance and indexed life insurance are all types of permanent life insurance that can include a cash value component.
How does cash value life insurance work?
When you buy a cash value life insurance policy, you pay an annual premium. Part of that premium covers the cost of the insurance you’re buying, while the remainder goes into a cash value account that pays interest. The cash value gradually grows, and increases for as long as you continue owning the policy.
As the policy’s owner, you can opt to surrender the policy and take its entire cash value or just part of it, depending on your financial circumstances. Some policies permit unlimited withdrawals. Others restrict how many times you can withdraw or put minimums on the amount you can take out with a single withdrawal — $500, for instance. Taking out all of the cash value automatically cancels the policy.
You use money that’s already taxed to pay premiums into the account, so the IRS doesn’t tax withdrawals up to the total amount of premiums you’ve paid. Your earnings grow tax-free while they stay inside the cash value part of your policy. However, any money you take out in excess of your premium total is taxed at your standard income tax rate.
How do you get the cash value of your life insurance?
Policyholders can withdraw cash from a cash value policy or borrow against it by taking out a loan.
Whatever cash you take out of the policy reduces your death benefit by the same amount. Let’s say for simplicity that you have a life insurance policy with a payout of $25,000 to your beneficiaries as a death benefit.
Suppose you take $5,000 out of the cash value portion of your policy. If you die the next day, your beneficiaries will receive $20,000 ($25,000 less the cash you withdrew).
If you take out a loan, the insurance company will charge interest. It might require you to repay the interest as well as the loan. If you die before completely repaying what you owe, the insurance issuer will deduct the amount outstanding from the policy’s death benefit.
Cash value can also be a way to pay policy premiums if there’s enough value in the account. Accumulate enough cash value and you may be able to stop paying premiums out of pocket because it will cover them.
Pros and cons of cash value life insurance
Like any financial product, cash value life insurance has pros and cons. Here are some benefits to this option and also aspects to it that may not be right for you.
Pros of cash value life insurance
- Offers permanent, lifetime coverage. It doesn’t expire after a specific number of years like a term life policy does.
- A policyholder can withdraw money from the cash value portion of a life insurance policy, though this may reduce the death benefit.
- Withdrawals are tax-free, up to the total amount of premiums you’ve already paid.
- A policy owner can also borrow against the cash value of the policy, typically without having to meet income requirements or show credit quality.
- The cash value increases over time.
Cons of cash value life insurance
- Cash value life insurance is more expensive than term life insurance; the higher premiums help fund the cash value portion of a policy.
- Withdrawals from the cash value part of a policy reduce the policy’s death benefit.
- Any unpaid loans against a policy are deducted from the policy’s death benefit.
Which life insurance policies generate immediate cash value?
Whole life insurance, universal life insurance, variable life insurance, and indexed life insurance are all types of permanent policies. As such, any such policies may include a cash value component. Whole life insurance policies generate immediate cash value, but it takes time to build that value up.
How do you calculate the cash value of a life insurance policy?
Some cash value life insurance policies earn an interest rate set by the insurance company; others fluctuate with prevailing market interest rates. Your insurance company can advise you on your policy’s current cash value growth.
Is cash value life insurance worth it?
Whether or not cash value life insurance is worth it depends on the person and their financial needs and goals. On the plus side, cash value life insurance offers cash value you can withdraw or borrow against in a tax-advantaged way, combined with lifelong insurance coverage.
On the minus side, coverage costs more than you would pay for term life insurance, which doesn’t have cash value and lasts only for a specific number of years. The right choice depends on you and your financial circumstances.
Cash value life insurance FAQs
Is there a limit to how much cash value in life insurance you can have?
There isn't a limit to how much cash value you can have in your life insurance policy. Some people use these types of policies as tax-deferred nest eggs.
Is cash value life insurance taxable?
Cash value life insurance pays a tax-free death benefit. Loans against a policy's cash value are tax-free, as are cash withdrawals up to the total you've paid in premiums. Cash withdrawals in excess of your total life insurance premium payments are taxed at your standard rate.
What happens to life insurance when the policy loan balance exceeds the cash value?
If the size of your loan exceeds your policy's cash value, the policy will lapse, canceling your coverage. You'll probably also have to pay tax on the loan amount.
How much can you borrow from cash value life insurance?
The total available loan amount varies by insurance company. You can generally borrow 90% or less of the policy's cash value.
Summary of our guide to cash value life insurance
Permanent life insurance — a category that includes whole life insurance, universal life insurance, variable life insurance and indexed life insurance — can include a cash value component within policies.
Policyholders can withdraw some or all of this cash value or borrow against it, in ways that offer tax advantages. Because these policies offer cash value, they typically require higher premium payments than insurance that doesn’t include this feature.
