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Life insurance can help keep loved ones safe from financial worry. Some types of life insurance include extra benefits such as having a cash value. If you're considering a cash value life insurance policy or just wondering how it works, this guide answers some of the most common questions.
Cash Value Life Insurance Defined
Some types of permanent life insurance policies, such as whole life or universal life, have a cash value feature in addition to the death benefit. Part of your premium goes toward the cash value portion and has the potential to grow. Life insurance with cash value provides a living benefit to policyholders by allowing them to borrow or withdraw from their policy.1
How Does Cash Value Life Insurance Work?
The main benefit of life insurance is that it provides a payout to cover expenses for your loved ones after you pass away, including funeral costs, outstanding debts, and ongoing living expenses.
When you purchase a permanent cash value policy, you start building cash value as you pay the premiums. The life insurance company will invest your premium payments, enabling it to provide the policy cash values. The way cash value grow depends on the type of policy purchased. If you take out a loan, the life insurance company will charge interest and reduce the death benefit by the outstanding loan balance until you pay the money back.
The policy owner can access policy cash value through loan or withdrawal. With some life insurance policies, you can use the accumulated cash value to help pay for premiums. So one downside of taking a policy loan is that the cash value is no longer available to help pay for premiums. Before taking out cash value, confirm that you can keep up with your premiums to avoid a lapse in the policy.
Finally, withdrawing a policy's cash value will reduce your death benefit amount. There's a trade-off between accessing the cash value while the insured is alive versus saving the full death benefit for the beneficiaries..
Types of Life Insurance Policies With Cash Value
Only permanent life insurance policies build cash value. These policies can last your entire life as long as you keep up with the premiums. There are several types of permanent life insurance policies with a cash value component:
Whole Life Insurance Policy
Whole life insurance charges a set premium that doesn't change. For cash value, the company provides guaranteed values that slowly grow over time. It's a steady way to build cash over time.
Universal Life Insurance Policy
With universal life insurance, you have some flexibility to adjust your premiums and/or death benefit to meet your changing needs. However, increases in coverage are subject to underwriting. There also must be enough cash value in the policy to cover monthly charges if a lower premium is paid than the amount selected at issue or if a premium payment is skipped.
Additional premium payments may be needed to maintain a policy during lower interest rates. With universal life insurance, cash value accumulation fluctuates according to market interest rates, so the amount you earn per year can go up and down.
Does Term Life Insurance Have Cash Value?
Term life insurance does not have a cash value component because it is temporary coverage.
If you die during this period, the policy pays your beneficiaries the death benefit. If you outlive the term, your coverage expires. With term life, you typically pay less per month but do not accumulate cash value in exchange.
What Are the Benefits of Cash Value Life Insurance?
Life insurance helps provide peace of mind for you and your loved ones, knowing that financial protection is in place in the event of an unexpected death. Life insurance with cash value, in particular, offers additional benefits beyond just a death benefit payout, such as savings and investment opportunities.
Here are some of the benefits of cash value life insurance.
It May Grow Over Time
Each time you pay your premium, you might increase your cash value. Your cash value also has the potential to grow over time.
It Can Provide Loans for Temporary Needs
If you only need money for a short amount of time, such as to pay for a car repair or vacation, cash value gives you the option to request a loan and then pay the money back.1
It Offers Potential Tax Advantages
Cash value typically grows tax-deferred. You may be able to defer taxes on cash value accumulation in your policy because gains are not taxed until money is received.
Options for Using Cash Value
Some of the ways you could use cash value include:
Paying Policy Premiums
Some policies allow you to use the cash value to help cover your life insurance premium. If you have cash value remaining, this may help you get a temporary break from paying your premiums. Your financial representative can provide more information on whether this may be right for you.
Withdrawing Money as Needed
Depending on your policy, you may be able to take withdrawals, which could be used to complement your other income, or you could save it for a major purchase such as a vacation.1
Turning It Into Guaranteed Future Income
If generating more retirement income is your priority, you could use the cash value from your life insurance policy to buy an annuity. An annuity is a contract between you and an insurance company that allows you to contribute money in a tax-deferred account. In return, you can get regular payments as income.
Keeping It for the Future
If you don't need extra money for now, another option is to do nothing with your cash value. It will continue to have the potential for cash value growth and will be there if you ever need the money in the future. Also, not taking any loans from your cash value will mean a larger death benefit.
Is the Cash Value of Life Insurance Taxable?
Tax rules for life insurance cash values are complex, but generally, you will not owe income tax on the cash value growth if you do not withdraw cash from your policy. IRS views life insurance cash value gains as taxable income, and as long as you don't withdraw the cash value gains in your policy, you will not owe income taxes.
When you take out cash value through a withdrawal, you can take out whatever amount you paid in premiums without paying taxes. You would only owe income tax once you take out cash value beyond what you paid for the insurance. For example, if you have paid $50,000 in premiums and you have $70,000 in cash value, you can withdraw up to $50,000 without paying taxes. If you need more than that, you would only owe tax on the amount withdrawn in excess of $50,000.
However, when you take out cash value gains through a loan, you don't owe income tax as long as the policy is active. The IRS considers an outstanding loan to be a withdrawal, resulting in taxes on the gains.
On the other hand, if you keep the policy going for the rest of your life and then die, the death benefit will first be applied to the outstanding loan, and your beneficiaries would receive the difference. Keep in mind that the insurer may charge interest on your outstanding cash value loan, and your beneficiaries would receive a reduced death benefit.
What Happens to the Cash Value of a Policy at Death?
When you die, your beneficiaries will receive the death benefit payment. The cash value balance is not added to or directly included in the death benefit, with few exceptions. The policy terminates, along with its cash value, upon payment of the death benefit. Taking out some of your cash value while alive, either through a loan or a withdrawal, may reduce the future death benefit.
As you weigh this information, meeting with a financial representative or tax professional could be helpful. They can answer your questions and help you decide how cash value life insurance may work for you.
Footnotes
- Loans will accrue interest, and loans and withdrawals may be subject to charges, withdrawals of taxable amounts are subject to ordinary income tax, and, if taken before age 59½, may be subject to a 10% IRS penalty) and loans (e.g., interest is charged on loans, they may generate an income tax liability, reduce the Account Value and the Death Benefit, and may cause the policy to lapse. A customer should always determine whether a withdrawal or a loan is preferable for their individual situation.
