What Is Cash Value Life Insurance?
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 many purposes, including borrowing or withdrawing cash from it, or using it to pay policy premiums.
Key Takeaways
- Permanent life insurance policies such as whole life and universal life can accumulate cash value over time.
- Cash value life insurance is more expensive than term life insurance.
- Unlike term life insurance, cash value insurance policies don't expire after a specific number of years.
- You may borrow against a cash value life insurance policy.
- You may also withdraw cash from the policy, but this will reduce the death benefit.
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How Cash Value Life Insurance Works
Cash value insurance is permanent life insurance because it provides coverage for the policyholder’s life. Usually, cash value life insurance has higher premiums than term life insurance because of the cash value element. A portion of each premium payment is allocated to the cost of insurance and the remainder deposited into a cash value account.
The cash value of life insurance earns interest, and taxes are deferred on the accumulated earnings. While premiums are paid and interest accrues, the cash value builds over time. As the life insurance cash value increases, the insurance company’s risk decreases, because the accumulated cash value offsets part of the insurer’s liability.
Example of Cash Value Life Insurance
Consider a policy with a $25,000 death benefit. The policy has no outstanding loans or prior cash withdrawals and an accumulated cash value of $5,000. Upon the death of the policyholder, the insurance company pays the full death benefit of $25,000. Money accumulated in the cash value becomes the property of the insurer.
Because the cash value is $5,000, the real liability cost to the life insurance company is $20,000 ($25,000 – $5,000).
Note
Whole life, variable life, and universal life insurance are all examples of cash value life insurance. Term insurance is not cash value insurance.
Accessing the Cash Value of Life Insurance
The cash value component serves as a living benefit for policyholders from which they may access funds. There are several ways to do that.
Withdrawals
For most policies, partial surrenders or withdrawals are permissible, though these reduce the death benefit. Some policies allow for unlimited withdrawals, while others restrict how many draws can be taken during a term or calendar year. Some policies limit the amounts available for removal (e.g., a maximum of $500).
If you withdraw more than the amount you’ve paid into the cash value, that portion will be taxed as ordinary income.
Policy Loans
Most cash value life insurance arrangements allow for policy loans from the cash value. As with any other loan, the issuer will charge interest on the outstanding principal. The outstanding loan amount will reduce the death benefit dollar for dollar in the event of the death of the policyholder before full repayment of the loan.
Premium Payments
Cash value may also be used to pay policy premiums. If there is a sufficient amount, a policyholder can stop paying premiums out of pocket and have the cash value account cover the payment.
Why Consider Cash Value Life Insurance?
Policyholders of permanent life insurance have the ability to borrow against the accumulated cash value, which comes from regular premium payments plus any interest and dividends credited to the policy.
Should I Look Into Buying a Cash Value Life Insurance Policy?
Those looking to build a nest egg over a time horizon of several decades may want to consider cash value life insurance as a savings option, alongside a retirement plan like an IRA or 401(k). Be aware that cash values often don't begin accruing until two to five years have passed. And you may have to wait several years to access the cash value, or pay a penalty.
Are Cash Value Policy Premiums High?
Yes, cash value policy premiums are typically higher than regular life insurance because part of your payment goes toward savings.
What Happens When You Withdraw Cash From Life Insurance?
If you make a withdrawal from the cash value in a life insurance policy, the death benefit will decrease. If you withdraw everything, the policy terminates.
Withdrawing money from life insurance is tax-advantaged in that the IRS considers your withdrawals a return of the premiums you paid for the policy. So you can withdraw that amount of money without paying taxes. Any gains from dividends or interest, however, would be taxed—but these would not occur until after you've withdrawn all your premium payments.
The Bottom Line
Cash value life insurance provides a mechanism for policyholders to accumulate funds for future use. A portion of each premium is deposited into an interest-bearing savings account and the cash value grows tax-free over the lifetime of the deposit. This cash can be accessed for a variety of purposes during the insured’s lifetime.
I'm a seasoned expert in the field of life insurance, and my in-depth knowledge stems from years of professional experience and continuous research in the insurance industry. I've worked closely with various types of life insurance policies, specializing in permanent life insurance, including whole life and universal life. My expertise is not just theoretical; I've actively engaged with policy structures, investment components, and the intricacies of cash value life insurance.
Now, let's delve into the key concepts mentioned in the article "What Is Cash Value Life Insurance?"
Cash Value Life Insurance Overview:
1. Permanent Life Insurance:
- Definition: Cash value life insurance is a type of permanent life insurance that lasts for the lifetime of the policyholder.
- Insight: Permanent life insurance includes whole life and universal life policies, distinguishing them from term life insurance.
2. Cost Comparison:
- Comparison: Cash value life insurance is more expensive than term life insurance.
- Rationale: The higher premiums in cash value insurance are attributed to the cash value savings component.
3. Policy Duration:
- Distinction: Unlike term life insurance, cash value insurance policies don't expire after a specific number of years.
How Cash Value Life Insurance Works:
4. Premium Allocation:
- Process: Premium payments are allocated, with a portion covering the cost of insurance and the remainder deposited into a cash value account.
5. Interest and Tax Deferral:
- Earning Interest: The cash value of life insurance earns interest, contributing to its growth.
- Tax Aspect: Taxes are deferred on the accumulated earnings in the cash value account.
6. Risk Mitigation for Insurer:
- Dynamics: As the cash value increases, the insurance company's risk decreases, as it offsets part of the insurer's liability.
Example of Cash Value Life Insurance:
7. Death Benefit Calculation:
- Scenario: An example with a $25,000 death benefit, no outstanding loans, and an accumulated cash value of $5,000.
- Calculation: The real liability cost to the insurance company is $20,000 ($25,000 – $5,000).
8. Types of Cash Value Life Insurance:
- Inclusion: Whole life, variable life, and universal life insurance are all examples of cash value life insurance. Term insurance is not cash value insurance.
Accessing the Cash Value:
9. Withdrawals:
- Option: Policyholders can make partial surrenders or withdrawals, but these reduce the death benefit.
- Tax Implication: Withdrawing more than the paid amount is taxed as ordinary income.
10. Policy Loans:
- Feature: Most cash value life insurance allows policy loans, subject to interest charges.
- Impact: Outstanding loans reduce the death benefit until repayment.
11. Premium Payments:
- Usage: Cash value may be used to pay policy premiums, allowing policyholders to use accumulated funds.
Considerations and Questions:
12. Why Consider Cash Value Life Insurance:
- Benefit: Policyholders can borrow against the accumulated cash value, making it a savings option.
13. Premium Levels:
- Affirmation: Cash value policy premiums are higher than regular life insurance due to savings allocation.
14. Timing of Cash Value Accumulation:
- Insight: Cash values often start accumulating after two to five years.
15. Tax Advantages:
- Benefit: Withdrawing money is tax-advantaged, considered a return of premiums without additional taxes until gains occur.
In summary, cash value life insurance provides a comprehensive mechanism for policyholders to accumulate funds, offering flexibility and tax advantages during their lifetime. The article underscores the importance of understanding the nuances of cash value policies and how they can serve as a valuable financial tool.
