When you buy life insurance, the main feature is that it will pay your heirs a death benefit after you pass away. But some life insurance policies also include financial benefits while you’re still alive. Cash value life insurance allows you to build up savings on top of the insurance protection. However, these policies have some drawbacks, including higher costs than other options.
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What is cash value life insurance?
Cash value life insurance is another name for permanent life insurance — or the type of life policies that last for the insured’s lifetime (assuming premiums are paid) and come with a savings component. “Cash value life insurance is a policy that you ‘pay into’ that results in an accumulation of a cash balance,” said Georgia Lord, a certified financial planner with Corbett Road Wealth Management in McLean, Virginia.
You gradually build up your cash value as you pay your life insurance premiums, and it grows based on interest rates or market performance, depending on the type of policy you have. You can then take out your cash value while still alive through withdrawals or loans or use it to cover future premium payments.
How cash value life insurance works
When you buy a cash value life insurance policy, the insurer charges ongoing premiums. “Your premium paid is split between the cost of the insurance itself, fees associated with holding the policy and the cash balance,” said Lord. Each premium payment builds up your cash value.
Depending on the type of cash value life insurance you have, your cash value balance either earns a fixed interest rate set by your insurer or is invested by your insurer or by you. With the latter, your account will grow or decline based on market performance and the investments’ returns. When you get a quote or buy a new policy, the insurer will give you a document called an illustration. It predicts how much your cash value will grow over time based on several factors.
During the first few years, your cash value usually grows very slowly. Over time, your balance grows faster, and you may earn a higher return.
Types of cash value life insurance
Only permanent life insurance policies build cash value — term life insurance policies do not. Permanent policies can last your entire life as long as you make the premium payments.
There are different types of life insurance policies with cash value, using different approaches for the premium payments and returns. This includes:
Whole life insurance
Whole life insurance charges a fixed premium that does not change. The insurance company pays a steady, guaranteed interest rate on your cash value. Whole life insurance offers the safest return out of cash value policies, though the actual rate of return can also be lower. “It’s a form of forced savings,” said Lord, as your premiums naturally get you to put money aside in a safe account.
Universal life insurance
Universal life insurance allows you to adjust your premiums, although certain limitations may apply. You must pay at least enough to cover the life insurance cost, so if your policy is underfunded, you may have to make higher payments to keep your coverage active. How much you pay in premiums also impacts how much cash value you generate: The smaller your premium payment, the lower the amount put into your account.
The cash value growth in a universal life policy depends on market interest rates, although your insurer may have a guaranteed minimum. Your return could be higher or lower each year, depending on the market. With an indexed universal life policy, your cash value returns are dependent on a market index like the S&P 500.
Variable life insurance
Variable life insurance lets you invest your cash value in market investments, like mutual funds, stocks and bonds. Your returns depend on how your investments perform. You can potentially earn more than the other types of cash value life insurance. However, you can also lose money with variable life insurance if your investments do poorly — you may even find that your death benefit amount will decrease due to poor performance, although a guaranteed minimum may apply.
Variable universal life insurance
Variable universal life insurance combines the flexible premiums of universal life insurance with the market investments of variable life. It operates similarly to a regular investment account, where you can control how much money goes in and your investments.
Pros and cons of cash value life insurance
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Pros explained
- Builds wealth on top of life insurance protection: Over time, your cash value balance could potentially grow larger than what you pay in premiums. Cash value life insurance is like buying a house, where you build home equity with your payments.
- Tax-deferred growth: You don’t owe income tax on your cash value gains as long as you keep the money in your policy. If you take out your cash value gains with a loan, you also will not owe income tax.
- No annual contribution limits: There are no contribution limits restricting how much you can contribute per year. Other types of investment vehicles like individual retirement accounts (IRAs) have annual contribution limits set by the IRS.
- Flexible ways to use the cash value: You can typically borrow or withdraw your cash value or use it to cover your premiums. You can also surrender (or cash in) the policy in exchange for the cash surrender value (your cash value balance minus any fees charged by your insurer). If you surrender your policy though, you’ll lose your life insurance coverage.
Cons explained
- More expensive than term life: Cost is one of the top reasons why some financial advisors believe cash value life insurance is “bad.” For example, a $500,000 whole life insurance policy can cost seven to 22 times more per month than a $500,000 term life insurance policy, depending on your age and gender, based on our study of the best life insurance companies.
- Loans may reduce the death benefit: Withdrawals and unpaid cash value loans can reduce the death benefit for your heirs. And, if you take out all the cash value and stop paying premiums, the coverage lapses, and you lose the life insurance protection altogether.
- Potential tax and interest complications: You can generally withdraw up to what you paid in premiums without owing taxes. However, if you withdraw more than this, your life insurance can become taxable and you can owe income tax for whatever you take out above what you paid. If you take out a loan, the insurance company charges interest until you repay the money. Additionally, if you completely pay off your life insurance policy in seven payments or less, it’ll be considered a modified endowment contract (MEC), and any withdrawals on the cash value growth will be subject to income tax. You’ll also receive an additional penalty if you’re younger than 59 1/2 years old.
- Building cash value takes time: It can take between two and five years to start building cash value and a decade or longer to earn substantial growth. It depends on your payment schedule and how much of your premium is allocated towards your coverage, your policy’s fees and your cash value account.
Is cash value life insurance right for you?
Now that you’ve seen the cash value life insurance pros and cons, how can you decide whether a policy is right for you? A cash value life insurance policy could make sense if you want life insurance on top of a way to build future savings, especially for retirement.
“The accrued cash value is available for you to access later in life as insurance needs decrease,” said Lord. For example, you may buy insurance when you have young children and need the death benefit for income replacement, mortgage payments and child-care costs. But after they grow up, you could tap into the cash value for your retirement.
If you want to save more but need help with discipline, cash value life insurance could “force” you to save. You’d get a monthly premium bill for the insurance, so it may be easier to manage your payments each month versus having to decide when to contribute to separate retirement and investment accounts.
Above all, buy enough life insurance coverage to protect your loved ones adequately. Cash value life insurance can be more expensive than term life, but you can still find cheap life insurance options that fit your needs and financial goals. Consulting a licensed insurance agent, financial advisor and a tax professional can help you make the best decision for your family.
Frequently asked questions (FAQs)
When you withdraw cash from life insurance, you have the option to choose a lump-sum payment or installments. The withdrawal will reduce the remaining cash value balance in the policy, and you may even see a decrease in your death benefit. You can withdraw up to what you paid in premiums without owing taxes. If you withdraw more than your total premium payments, you owe income tax for any gains taken out.
You could also take out a cash value loan and pay it back when you want. The insurance company charges interest as long as you have an outstanding loan, and any remaining balance will be deducted from your death benefit before paid to your beneficiaries.
Yes, premiums for cash value policies are substantially higher than for term life. This is because cash value policies provide permanent life coverage that doesn’t expire as long as you keep up on your payments. They also cost more because the higher premiums help fund your cash value account.
The factors that determine your cash value balance include:
- The size of your monthly premiums: In general, the more premiums you pay into a life insurance policy, the larger your cash value.
- The amount of time you had the policy: The longer you’ve had your policy, the more time your cash value will have to grow.
- The cost of your life insurance coverage and fees: The lower your insurance costs and fees, the more your premiums go toward building cash value.
- Your interest rate or investment performance: The higher your cash value interest rate is or the better your investments perform, the faster your cash value will grow.
It depends on which type of policy you have. If you own a universal life policy, you have two options for cash value: paid out as part of your death benefit (level) or in addition to your death benefit (increasing). If you have the former, your policy’s beneficiaries will receive no more than the listed death benefit amount minus any outstanding cash value loan amounts. If you have the latter, your plan’s beneficiaries will typically receive more than the policy’s face value.
However, if you have a whole life policy and you pass, the insurer will likely take your cash value and pay out the death benefit.
You only pay taxes on your cash value when you withdraw any gains or surrender your policy and receive more than the sum of the total premiums paid. You can also owe taxes on your cash value if you pay your life insurance up in seven or less payments so the policy legally becomes a MEC.
The cash surrender value of life insurance is the amount you get if you cancel the policy and “cash it in.” You get back your cash value minus any outstanding cash value loans and cancellation or surrender fees from the insurer. Your insurance company should tell you the cash surrender value on your policy statements and online account.
