Understanding the Cash Value in Your Life Insurance Policy
Shopping for life insurance can be a daunting task. With different policy types, riders and head-scratching terminology (accelerated death, anyone?), it can be hard to decipher what makes the most sense for your own financial situation.
One component of life insurance that often leaves people confused is cash value. This is a feature that’s often offered within permanent life insurance policies.
Policyholders can use the cash value as an investment-like savings account and take money from it.
Here’s what you need to know.
What is Cash Value in Life Insurance?
A cash value feature in life insurance typically earns interest or other investment gains and grows tax-deferred.
With cash value life insurance, your premium payments go three places:
Into the cash value.
Toward the cost of actually insuring you.
Toward policy fees and changes.
So only a portion of what you pay is going to end up in cash value.
You have several options if you want a cash value life insurance policy. Each policy type accrues cash value differently, but in all cases you can get to your cash value with a loan, withdrawal or surrender.
Whole life insurance offers a fixed monthly premium and a guaranteed death benefit. Your premium payments don’t change over the course of time. Cash value will accumulate at a minimum guaranteed rate. If you receive company dividends and pour those into your whole life insurance cash value every year you can build the account up faster.
Universal life insurance can provide more flexibility than whole life insurance. With some types of universal life insurance you may have the option to adjust your death benefit and reduce your premiums, as long as there is enough in the cash value account to cover the costs of the policy.
How Can You Access the Cash Value?
You can withdraw money from cash value or take a loan against it and use the money for anything you want: for an emergency, to supplement retirement income, to pay premiums, or anything you like.
Let's get specific.
Take Out a Loan
One option is to borrow against the cash value of your permanent life insurance policy. Your loan amount will accrue interest until it’s paid back in full.
The interest on a policy loan may be fixed or a variable rate that’s calculated by the insurer based on current market rates.
If you don’t repay the loan amount and you pass away, the outstanding loan balance (including interest) will be subtracted from the life insurance payout to your beneficiaries. Some policyholders choose to use their cash value this way and intend for their beneficiaries to get a reduced payout.
Another perk to a policy loan is that it doesn’t appear on your credit report.
Withdraw Funds From Cash Value
It’s also possible to take withdrawals from your policy. If the amount you withdraw includes investment gains that portion is taxable. As with taking a policy loan, making a withdrawal will reduce the life insurance payout to your beneficiaries later on.
Surrender the Policy for Cash
Surrendering an insurance policy means you’re canceling the coverage. When you surrender a policy, you can get back the cash value minus any surrender charge. The insurance company will also subtract any unpaid premiums or outstanding loan balance. Still, getting some money back is better than simply walking away from the policy empty-handed if you no longer want it.
Using Cash Value to Pay the Premiums
If you build up enough money in your cash value account, you may be able to use your cash value to cover premium payments, depending on the policy. If you’re struggling to make the payments, this option could provide some relief so that you can keep the life insurance in force.
If you drain all the cash value from the account, the policy could lapse, so be aware of your cash value level.
Many whole life insurance policies are “participating,” meaning the policy owner can potentially get dividends if they’ve bought from a mutual insurance company. Dividends can be taken as cash, or added to your cash value, or used to pay premiums. Dividends can also be used to buy “paid up additions” to your life insurance policy, which will increase the death benefit amount for beneficiaries.
Having a participating policy is a way to lower your overall life insurance cost.
Tax Advantages of Cash Value Life Insurance
There can be several tax advantages to purchasing life insurance and, specifically, a cash value life insurance policy. A primary tax perk is that your beneficiaries receive the death benefit tax-free, as with any type of life insurance. Since life insurance payout amounts are usually pretty large, this is an important advantage.
Another tax advantage is that the total cash value accumulates on a tax-deferred basis. Also, if you borrow money against the policy, you won’t have to pay taxes on the loan, just as you wouldn’t pay taxes on a personal loan. The loan is not taxable as long as the policy is in-force.
If you withdraw cash value, or take the surrender value and terminate the policy, you can be taxed on the portion of money that came from interest or investment gains.
When Does It Make Sense to Purchase a Cash Value Policy?
While term life insurance is generally plenty of coverage for most people, cash value life insurance is useful under a few circumstances. For starters, these policies only make sense for those who can afford them. The premiums can be much higher than the same amount of term life insurance because of the cash value feature and policy fees.
A cash value insurance policy could be a good option for high-income earners who have maxed out retirement account contributions and want an additional account for tax-deferred savings.
Some high net-worth individuals use cash value policies to help their heirs pay estate taxes.
Notes of Caution About Cash Value Policies
Because some policies take a long time to build up any significant cash value, you could wait decades before you have a substantial amount to access. Other policies are designed to build up cash value more rapidly in the early years of the policy.
Let's discuss these options and more. Please connect with me to make an appointment.