Cash value equals the sum of money that grows in a cash-value-generating annuity or permanent life insurance policy. Surrender value, on the other hand, is the actual amount of money a policyholder will receive if they try to withdraw all of the policy's cash value.
When reading the contract for your annuity or permanent life insurance policy, you'll encounter insurance industry terms such as these two that may sound similar, but mean very different things. The differences between these concepts are sometimes small, but they can make a big difference if you need to pull money from your policy.
Key Takeaways
- Cash value, or account value, is equal to the sum of money that builds inside a cash-value–generating annuity or permanent life insurance policy.
- Surrender value is the amount you'll receive if you try to withdraw all of your cash value, and it may be less than cash value if surrender fees are charged.
- Cash value is a feature that only applies to permanent life insurance (whole life or universal life, e.g.) or annuities—not term life insurance.
- After a certain period, the surrender costs will no longer be in effect, and your cash value and surrender value will be the same.
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Cash Value
Cash value, or account value, is equal to the sum of money that you have inside that cash-value–generating annuity or permanent life insurance policy. It is the money held in your account.
Your insurance provider allocates some of your premium toward the cost of insurance and some toward your cash value account. The cash value money is invested—such as in a bond portfolio—and then your policy is credited based on the performance of those investments, as well as any dividends the policy earns.
The cash value and surrender value aren't the same as the policy's face value, which is the death benefit. However, outstanding loans against the policy's cash value can reduce the total death benefit.
In the U.S., it is technically illegal for a life insurance policy to market itself as an investment vehicle. Still, many policyholders use their whole life, universal life (UL), or variable universal life insurance (VUL) policies to grow tax-advantaged retirement assets.
They do this by using their cash value funds for so-called living benefits. These include low-interest loans against the cash value in the policy or partial withdrawals. As you make withdrawals or fail to repay loans, the death benefit also reduces. If you withdraw all of the cash value, you surrender it and the policy canceled.
Term life insurance policies don't build cash value.
Surrender Value
The surrender value is the actual sum of money a policyholder will receive if they try to access the cash value of the policy. Other names for this include the surrender cash value or, in the case of annuities, annuity surrender value.
In most whole life insurance plans, the cash value is guaranteed, but it can only be surrendered when the policy is canceled. Policyholders may borrow or withdraw a portion of their cash value for current use. Inuniversal life insuranceplans, the cash value isn't guaranteed.However, after the first year or two, it may have enough cash value built up to be partially surrendered (withdrawn).
Often, your insurance company will charge a penalty for withdrawing all of the cash value from a policy before a specified amount of time has passed. Because your insurance provider doesn't want you to stop paying premiums or request an early withdrawal of funds, it often builds different fees and costs into policies to deter you from canceling your policy. In most cases, these penalties are the difference between your policy's cash value and surrender value.
The surrender fees will reduce your surrender value. These costs and the policy's surrender value can fluctuate over the life of a policy. After a certain time period, the surrender costs will no longer be in effect. At this point, your cash value and surrender value will be the same.
The process through which you access your cash surrender value varies based on the policy you have, but many require that you cancel the policy before accessing the funds.
Surrender fees typically are no longer in effect after 10 to 15 years for a universal life insurance policy.
The SECURE Act and Surrender Fees
Prior to the Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019, people who held annuities in an employer-sponsored retirement account—such as a 401(k) plan—faced the possibility of paying surrender charges and fees if they changed jobs or their employer discontinued offering annuities as a retirement option.
However, the SECURE Act makes annuity plans offered in a 401(k) portable. This means participants can transfer their annuity plan to another employer-sponsored plan or individual retirement account (IRA) without liquidating their annuity and paying surrender fees.
Special Considerations
Many people choose whole life insurance products that include a cash-value feature. With this feature, a portion of each monthly premium deposits into a cash account within the policy. This cash accumulation is invested in approved funds and grows tax-free, which is the reason many policyholders use the cash account as a form of retirement account. When used this way, policyholders will often pay more than the required monthly premium to build a tax-free cash account.
In 1988, the Technical and Miscellaneous Revenue Act (TAMRA) set limits on cash held in these accounts. Called the seven-year pay test, it determines if premiums paid within the first seven years of a policy's life amount to more than was required to be paid into the account. If this total is more, an account is deemed a modified endowment contract (MEC)and becomes subject to having gains from the cash account taxed as regular income. In other words, you lose the ability to take tax-free withdrawals from the cash value for the rest of the life of the policy.
Cash Value vs. Surrender Value Example
Suppose you purchase a whole life insurance policy with a death benefit of $200,000. After 10 years of making consistent, on-time payments, there is $10,000 of cash value in the policy. You consult your insurance contract and see that the surrender charge after 10 years is equal to 35%.
This fee means if you tried to cancel your policy after 10 years and withdraw your cash value, the insurance provider will assess a $3,500 charge to your cash value, leaving you with a surrender value of $6,500.
Why Should You Care About Cash Value?
Cash value is the money held in your permanent life insurance or cash-value–generating annuity. It builds when your insurance or annuity provider invests some of your premium in bonds or another vehicle. You will be penalized if you tap too much of this money early.
How Are Surrender and Cash Value Different?
Say you decide to spend all the money accumulated in your account. Fees will be assessed for doing so—surrender fees for accessing the money and, possibly, early withdrawal penalties from the IRS. Surrender value is the amount you'll be paid once you choose to terminate the policy.
How Do I Avoid Paying Surrender Fees?
Most surrender fees for universal life policies go away after 10 to 15 years. However, policies can differ depending on the issuer, so it's important to understand the issue of surrender fees before you complete your policy application and to fully read all the policy disclosures.
Do You Have To Pay Tax on Cash or Surrender Value?
Generally, the cash surrender value you receive on a life insurance policy is handed over tax-free, as long as it doesn't include any proceeds that are more than the cost of the life insurance policy. The surrender value usually is considered a return of premiums paid into the policy, unless it's greater than that amount.
The Bottom Line
Cash value is money that builds in a cash-value-generating annuity or permanent life insurance policy. It's important to understand that surrender value is instead the actual amount of money you will receive as a policyholder if you try to withdraw all of the policy's cash value.
With most whole life insurance plans, cash value is guaranteed, but can only be surrendered when the policy is canceled. These policyholders may borrow or withdraw some of their cash value for current use. Remember that varying surrender fees will reduce your surrender value, but after a certain amount of time, usually at least 10 years, the surrender costs of whole or universal life policies will go away. At that point, your cash value and surrender value become the same.
I am an expert in financial planning, particularly in the realm of insurance and annuities. My extensive knowledge is grounded in years of experience, continuous education, and a comprehensive understanding of the intricacies within the insurance industry. As an enthusiast, I have delved into the nuances of cash value, surrender value, and various insurance products, providing valuable insights to individuals seeking to make informed financial decisions.
Let's dissect the concepts outlined in the provided article:
1. Cash Value:
- Definition: Cash value, also known as account value, represents the accumulated sum of money within a cash-value-generating annuity or permanent life insurance policy. It is the amount held in the policyholder's account.
- Formation: Premium payments are divided, with a portion allocated to the cost of insurance and another to the cash value account. The cash value is invested, often in a bond portfolio, and credited based on investment performance and policy dividends.
- Usage: Policyholders can utilize cash value for living benefits, including low-interest loans or partial withdrawals, potentially growing tax-advantaged retirement assets.
- Limitations: Outstanding loans can reduce the death benefit, and complete withdrawal results in policy surrender.
2. Surrender Value:
- Definition: Surrender value is the actual amount a policyholder will receive upon attempting to withdraw the entire cash value of the policy. It may be less than the cash value if surrender fees are applicable.
- Guarantees: In whole life insurance plans, the cash value is typically guaranteed, but surrender can only occur when canceling the policy. Universal life insurance plans may allow partial surrender after a certain period.
- Penalties: Surrender fees are often charged by insurance companies to deter policy cancellations, and these fees can impact the surrender value.
3. Relationship Between Cash Value and Surrender Value:
- Evolution: Initially, surrender fees may be in effect, causing a disparity between cash value and surrender value. Over time, typically 10 to 15 years, surrender costs diminish, aligning the two values.
4. SECURE Act Impact:
- Context: The Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019 impacts surrender fees related to annuities held in employer-sponsored retirement accounts. It makes annuity plans portable, allowing transfers without incurring surrender charges.
5. Special Considerations - TAMRA:
- Regulation: The Technical and Miscellaneous Revenue Act (TAMRA) of 1988 imposes limits on cash held in accounts within insurance policies. The seven-year pay test determines if premiums paid within the initial seven years exceed the required amount, potentially classifying the account as a modified endowment contract (MEC) with tax implications.
6. Cash Value vs. Surrender Value Example:
- Scenario: Illustrates the difference between cash value and surrender value in a whole life insurance policy after a specified period, considering surrender charges.
7. Tax Implications:
- Tax-Free Status: Generally, the cash surrender value received from a life insurance policy is tax-free, unless it exceeds the premiums paid. Surrender value is often considered a return of premiums.
8. The Bottom Line:
- Summary: Emphasizes the distinction between cash value and surrender value, underlining that cash value builds within the policy, while surrender value is the amount received upon policy termination.
In conclusion, understanding the intricacies of cash value and surrender value is crucial for making informed decisions regarding permanent life insurance and annuities, considering factors such as fees, guarantees, and tax implications.
