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Life insurance, whether term or cash value, is a way to protect your dependents in the event you’re no longer able to contribute to their financial well-being. What’s the difference between the two forms of life insurance? And how does cash value life insurance work?
Cash value life insurance, also known as permanent life insurance, does two things. It pays out when the policyholder dies, and it accumulates value while the policyholder is alive. You can use cash value life insurance as a form of tax-sheltered investment and earn modest returns on your premium payments. You can even use the earnings from your policy to pay the monthly premiums or withdraw cash for income. Whole life, variable life and universal life are all forms of cash value life insurance.
The alternative to cash value life insurance is term life insurance. With term you insure yourself for a specific number of years, say until your kids graduate college or the mortgage is paid off. If you die within the term, the insurance company pays up. If you outlive the term (and we certainly hope you do) the policy ends and you don’t get any money out of it.
Many people don’t like the fact that, with term life insurance, you pay premiums each month and don’t see any of that money back at the end of the term. For these people a cash value insurance policy may sound like a more appealing option. Read on to find out some cash value life insurance pros and cons.
The pros of cash value life insurance
- Access to your premiums: With term life insurance, the money you pay to the insurance company in premiums is lost forever (except with a return of premium policy). The insurance company keeps it and you have no further claim on it. But with cash value life insurance, part of the money you pay in premiums contributes to your cash value account and forms your "basis" in the policy. You can borrow from your cash value account tax-free later down the line. Depending on the specifics of your policy there may be fees. Wondering how to calculate the cash surrender value of your life insurance? Its cash value is the stated face value of the policy. The amount you can access without paying taxes is the face value minus your basis and any withdrawals you’ve already made.
- Tax-free earnings: The cash value of your life insurance policy and the earnings that it makes grow tax-free. When you withdraw money, as long as you only withdraw up to the amount you’ve paid in premiums, you won’t owe any taxes on that money. If you withdraw more than that, though, you are actually taking out some of the interest your money has earned. In this case you’ll have to pay taxes on the difference between what you paid in and what you’re taking out. In other words, a chunk of your policy’s cash surrender value is taxable.
- Money in your pocket: If you want to access the cash value of your policy, you are free to do so. You can withdraw the money to help pay for retirement or to pay your life insurance premiums. You can also take out a loan against the cash value of the policy, though if you die without paying the loan back, your beneficiary’s payout will be lowered by the amount of the loan. If you borrow against the full value of your life insurance policy and then get hit by a bus (sorry) before you pay back the loan, your family won’t get anything.
- You’re insured regardless of how your health evolves: With term life insurance, if your health declines over the coverage term and you need to re-up your coverage (buy another term), you may have a hard time doing so or you may need to pay higher premiums. But with a cash value life insurance policy, you are covered even if changes in your health, lifestyle or occupation make you more of a risk to the insurance company. You will generally pay a flat — but high — rate for premiums for your whole life.
The cons of cash value life insurance
- Earnings won’t go to beneficiaries: When you die, your beneficiary will get the face value of your policy (the amount your life was “worth”) and won’t see any of the earnings. The investment feature of cash value life insurance only works to your benefit if you tap the money while you’re alive. In other words, cash surrender value accounting differs depending on whether the original policyholder is the one accessing the money or whether the money passes to a beneficiary. Any cash value life insurance calculator worth its salt will take this difference into account.
- Low rate of return: Compared to stocks, the investment portion of cash value life insurance makes pretty paltry returns. Could you make more if you invested the money elsewhere? Likely yes — unless you are an extremely conservative investor.
- High fees and commissions: Cash value life insurance policies can come with high fees and agent commissions, both of which take a chunk out of your investment earnings. You may also get hit with a surrender charge if you decide to withdraw from the policy, even if you only withdraw up to the value of your basis.
- High premiums: Compared to term life insurance, cash value life insurance will saddle you with hefty monthly premiums.
- Loans carry interest: If you don’t want to pay the surrender charge for withdrawing money from your policy, you can access the funds by asking the life insurance company for a loan, with the policy value as collateral. The insurance company will charge you interest for the privilege, though.
Alternatives to cash value life insurance
- Build up savings in another vehicle: Cash value life insurance isn’t your only option for building up savings. If risk isn’t your thing, you may want to consider bonds and CDs.
- Invest your money: That’s right, we’re talking about the stock market. If you’re tempted by a cash value life insurance policy you’re probably a conservative investor, which could mean you’re nervous about investing in stocks (also known as “equity exposure”). But if you want to see big returns on your money and you can afford to weather some ups and downs in the market, investing in an index fund with a low expense ratio just might be your best bet.
A note to the super-rich…
Photo credit: © iStock/Predrag Vuckovic
Hey there. If you have a very high net worth (you know who you are) you’re probably concerned about how your family will cover all the estate taxes that the government will claim when you die. A life insurance policy can be a good way to earmark money for paying off estate taxes. Why? Because the policy payout can pass straight to your spouse when you die, without going through probate court and without being subject to estate taxes. This only works if you name your spouse as the beneficiary rather than naming your estate as the beneficiary. Then, he or she can use the life insurance money to pay the Tax Man.
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All whole life insurance policy guarantees are subject to the timely payment of all required premiums and the claims paying ability of the issuing insurance company. Policy loans and withdrawals affect the guarantees by reducing the policy’s death benefit and cash values.
2
Guardian, its subsidiaries, agents, and employees do not provide tax, legal, or accounting advice. Consult your tax, legal, or accounting professional regarding your individual situation.
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Dividends are not guaranteed. They are declared annually by Guardian’s Board of Directors.
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Policy benefits are reduced by any outstanding loan or loan interest and/or withdrawals. Dividends, if any, are affected by policy loans and loan interest. Withdrawals above the cost basis may result in taxable ordinary income. If the policy lapses, or is surrendered, any outstanding loans considered gain in the policy may be subject to ordinary income taxes. If the policy is a Modified Endowment Contract (MEC), loans are treated like withdrawals, but as gain first, subject to ordinary income taxes. If the policy owner is under 59 ½, any taxable withdrawal may also be subject to a 10% federal tax penalty.
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The premium offset year is not guaranteed and relies on the payment of nonguaranteed dividends and the amount of paid-up additions in the policy in order to pay for the policy’s required premium.
Editorial Note: We earn a commission from partner links on Forbes Advisor. Commissions do not affect our editors' opinions or evaluations.
Shopping for life insurance can be a daunting task. It can be hard to decipher what makes the most sense for your financial situation with different policy types, riders and head-scratching terminology (accelerated death, anyone?).
Cash value is a component of some types of life insurance. This is a feature that’s typically offered within permanent life insurance policies, such as whole life and universal life insurance.
Policyholders can use the cash value as an investment-like savings account and take money from it.
While buying cash value life insurance may seem like a smart choice, it’s not always the right one. Here’s what you need to know about cash value life insurance.
What Is Cash Value Life Insurance?
Cash value life insurance is a policy that contains a cash value account. This cash value component typically earns interest or other investment gains and grows tax-deferred.
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 through a loan, withdrawal or surrender. Here are five types of cash value life insurance.
Types of Cash Value Life Insurance
Whole life insurance
Whole life insurance is a type of permanent life insurance that’s possibly the simplest cash value policy. Whole life insurance policyholders don’t have to decide on how the cash value should be invested. The insurance company provides a fixed rate of return to grow the cash value.
Here’s a summary of whole life insurance:
- Offers a fixed monthly premium and a guaranteed death benefit.
- Your premium payments don’t change over time.
- Cash value accumulates at a minimum guaranteed rate.
- You can build cash value faster if you receive company dividends and put those into your cash value account every year.
- The guarantees of whole life insurance make it a pricier life insurance option than some others.
Guaranteed issue life insurance
Guaranteed issue life insurance is a type of whole life insurance. You can’t be turned down, and the application process has no medical exam or health questions. These whole life policies are sometimes referred to as burial insurance, funeral insurance or final expense insurance.
- Often available only in small coverage amounts, such as $20,000.
- May include cash value, but since coverage amounts are small, the potential cash value is small.
- Guaranteed issue life insurance has a graded death benefit: Your beneficiaries won’t get the full payout if you pass away within two or three years after buying the policy, unless the death was due to an accident. Exact rules on graded death benefits can vary, so make sure you understand them before buying guaranteed issue life insurance.
Universal life insurance
Universal life insurance policies are the most common cash value life insurance policies. Not all types of universal life build cash value well, so make sure you understand what you’re buying if you’re looking for cash value growth.
- Some types of universal life offer the ability to accumulate greater cash value, but also with some risk of loss.
- Some types of universal life give policyholders the option to adjust death benefits and premiums, within certain limits.
Let’s dig deeper to show the difference among universal life insurance types.
Guaranteed universal life insurance
- Similar to whole life insurance because premiums are steady.
- Cash value accumulation may be minimal.
- Usually the least expensive universal life insurance option.
Indexed universal life insurance
- Growth of your cash value is connected to gains and losses in an index, such as the S&P 500.
- You can typically adjust premiums and death benefits within certain parameters.
Variable universal life insurance
- Growth of cash value is tied to sub-accounts, including stocks and bonds, that contain investments you choose.
- You can generally change your premium and death benefits within set limits.
- Your investment decisions could result in losing money in your cash value.
How Does Cash Value Life Insurance Work?
Premium payments for cash value life insurance go three places:
- Into the policy’s cash value
- To the cost of actually insuring you
- Toward policy fees and changes
So only a portion of what you pay winds up in cash value.
You can withdraw money from cash value or take a loan against it and use the money for anything you want. That could be for an emergency, supplementing retirement income, and paying premiums. There’s no limit to how you can use cash value.
You can also take your cash value if you decide to end the policy. If you terminate the policy with the insurer, you receive the cash value amount minus any surrender charge. This action ends the life insurance coverage.
There is typically a surrender charge if you terminate the policy within the first several years after buying it. The surrender charge is a way for the insurer to cover the cost of issuing you the policy.
How to use cash value to pay 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. 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.
Talk with your insurance company to find out their rules for using cash value toward your premiums.
You can tap into a policy’s cash value while you’re alive with the methods below.
Take out a loan against the cash value
You can borrow against the cash value of a permanent life insurance policy. Your loan amount accrues 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.
State law often dictates the maximum policy loan interest rate. For example:
- California lets insurance companies charge a maximum fixed rate of up to 8% a year.
- Florida allows up to 8% for a maximum fixed rate.
- New York allows insurers to charge up to 7.4% interest on a fixed loan and up to 8% on policies with adjustable rates.
- Texas law says the maximum fixed rate can’t exceed 10% a year. Texas allows up to 15% for policies with an adjustable maximum interest rate.
If you don’t repay the loan amount and you pass away, the insurance company subtracts the outstanding loan balance (including interest) 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, often referred to as the part “above basis,” that portion is taxable. As with taking a policy loan, making a withdrawal reduces the life insurance payout to your beneficiaries later.
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 also subtracts 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.
Benefits of Cash Value Life Insurance
Whether cash value life insurance is right for you depends on why you want a policy. Here are the benefits of a cash value life insurance policy.
Your beneficiaries receive a death benefit
Cash value life insurance is a permanent life insurance policy, which means it can remain in effect until you die as long as you pay your premiums. If you take loans or withdrawals from the policy, you also have to make sure you maintain a minimal cash value level or your policy could lapse.
If you want to make sure your loved ones get something, a cash value policy is likely the better option than term life insurance.
Participating life insurance policies can have dividends
Many whole life insurance policies are “participating,” meaning the policy owner can potentially get dividends if the policy is from a mutual insurance company.
Dividends can be:
- Taken as cash
- Added to your cash value
- Used to pay premiums
Dividends can also be used to buy “paid up additions” to your life insurance policy, which increases the death benefit amount for beneficiaries.
Having a participating policy is a way to lower your overall life insurance cost.
Riders for extra coverage
Most types of life insurance have options for adding policy riders that tack on extra coverage or features. One of the most common life insurance riders is an accelerated death benefit, which is often automatically included. This gives you access to your own death benefit while you’re still alive if you’re diagnosed with a terminal illness. It can be useful for paying medical bills and other unexpected costs.
Similar riders for chronic illness and long-term care also let you tap into your death benefit if you have certain medical conditions. Your life insurance agent can tell you the rider options available with your policy before you buy it.
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 can be pretty large, this is an important advantage.
Another tax advantage is that the total cash value accumulates on a tax-deferred basis. So as your cash value grows, the IRS doesn’t take a cut.
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 isn’t 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 the money that came from interest or investment gains.
Therefore, it’s important to understand tax rules before taking out money so you don’t get hit with a surprise tax bill.
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Drawbacks of Cash Value Life Insurance
Cash value life insurance isn’t for everyone. Here are some potential negatives to cash value life insurance.
Cash value life insurance is more expensive than term life
Cash value insurance costs more than term life insurance.
If you need life insurance because you want to cover a specific debt or a certain amount of time, look at term life insurance. It doesn’t offer a cash value component, but it will pay out a death benefit amount of your choice if you pass away while the policy is in force.
Term life insurance is ideal for covering the years you’re paying a mortgage or the years until your children are expected to be financially independent. And it won’t cost you an arm and a leg like some forms of cash value life insurance, such as whole life insurance. If you don’t need insurance for the duration of your life, term life insurance will give you the most coverage bang for your buck.
Many term policies also let you convert term life to permanent life insurance later.
Life insurance is designed as a financial safety net for your loved ones if something happens to you. While cash value life insurance may seem enticing, it doesn’t make sense to pay the higher price tag if you don’t need insurance indefinitely.
Related: Comparing Term Life Vs. Whole Life Insurance
Cash value can take time to build
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. There are some life insurance policies designed for faster cash build up in the early years of the policy. Work with an experienced life insurance agent who can guide you toward the right products.
Cash value is not paid to beneficiaries
When you pass away, cash value typically reverts to the life insurance company. Your beneficiaries receive the policy’s death benefit amount, minus any loans and withdrawals of cash value you made. That said, there are some policies that will pay out the death benefit plus cash value to beneficiaries, but be prepared to pay substantially more for this feature.
Cash Value Life Insurance FAQ
Not every type of life insurance has a cash value component. For example, term life insurance does not have a cash value component.
Whole life and universal life are forms of life insurance that have a cash value component.
It can take decades to build a substantial cash value, but some policies are designed to accumulate a cash value more quickly in the early years of the policy.
For example, New York Life’s Custom Whole Life policy is designed to accumulate cash value faster than a regular whole life insurance policy.
You can withdraw money or take a loan against your cash value and use the money for anything you like. If you decide to terminate the policy, you can take the cash value (minus any surrender charge).
If you withdraw money from the cash value and the amount you withdraw includes interest or investment gains (known as “above basis”), you will be taxed on that portion of the withdrawal.
Cash value is an attractive option for some life insurance buyers, but shouldn’t be your first investment option. Instead, first maximize other savings options like IRAs and 401(k)s.
If you’ve already maxed out your retirement account contributions and want an additional account for tax-deferred savings, a cash value life insurance policy might be a good fit.
If you just want life insurance for covering financial obligations with a known end, like a mortgage or a child’s college tuition, a term life insurance policy is a better fit.
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