What is cash value life insurance?

Cash value life insurance explained

Cash value life insurance refers to different types of life insurance policies that have a savings component. Cash value typically accrues within a permanent life insurance policy such as whole or universal life insurance.

With a cash value life insurance policy, a portion of your insurance premiums goes toward building the cash value within the policy. The cash value earns interest or in some cases may be invested to potentially grow in value.

How does cash value life insurance work?

Cash value life insurance has two main components — a death benefit and cash value. The death benefit is the amount that is paid out if you die while the policy is in force. For most cash value life insurance policies, the death benefit lasts for your entire lifetime.

The cash value within a life insurance policy accrues over time as you fund the policy through insurance premiums. For most cash value policies, the cash value earns interest or is invested in securities such as stocks or exchange-traded funds (ETFs).

The cash value also grows tax-free in most policies, with taxes deferred until you withdraw the cash value after age 59 ½. In addition, you can borrow against the cash value within a life insurance policy tax-free — making it an option to borrow against your balance at any time without any tax implications.

The downside of a cash value life insurance policy is the cash value usually does not get paid out to the insured upon death — only the death benefit amount. Plus any loans against the cash value of the policy must be repaid before the death benefit is paid out, further reducing the benefits of a cash value policy.

Example of cash value life insurance

If you purchase a whole life policy with a death benefit of $100,000, you will start paying premiums monthly and accruing cash value. After 10 years, let’s say the cash value accumulated is around $20,000. You can borrow against the cash value of the policy — but usually no more than 90% of the total cash value.

This means you can take a $9,000 tax-free loan against the policy. While interest rates may be on par with a personal loan, your cash value will still accumulate interest, effectively making the interest rate of the loan much lower.

Upon death, the insurer will pay out $100,000 minus the outstanding $9,000 loan balance for a total death benefit of $91,000. The cash value of the policy goes back to the insurance company.

Types of cash value life insurance policies

There are several types of cash value life insurance policies available:

• Whole life insurance: Whole life insurance is a type of permanent life insurance with a death benefit and cash value that accrues interest at a fixed rate in most cases. If your insurer is a mutual fund company, you may also earn dividends from the company within the cash value of the policy.
• Indexed universal life insurance: Indexed universal policies are a type of permanent life insurance that builds cash value and earns interest based on the performance of a linked index, such as the S&P 500. There is usually a “no-loss” guarantee meaning you won’t lose money if the market is down. But there are also earnings caps that may not allow you to earn more than a certain percentage in a given year.
• Variable life insurance: Variable life insurance is a permanent life insurance policy with the most flexibility, allowing you to invest the cash value of the policy into mutual funds or individual investments such as stocks or bonds. These policies don’t usually have earnings caps but also have the most downside risk, as you may lose money if your investments drop in value.

Pros and cons of cash value life insurance

Cash value life insurance policies can help you accrue savings in a tax-free insurance policy and borrow against the value at a low interest rate. But cash value policies typically come with high fees and commissions and may end up costing you more than just getting a term life insurance policy and investing the difference.

Here are a few pros and cons to consider with cash value life insurance:

How to use cash value life insurance policies

Cash value life insurance policies may be particularly useful for estate planning and asset protection, according to Marty Burbank, the founder of the firm OC Elder Law in Fullerton, California.

“For instance, one of my clients used a whole life insurance policy to ensure their grandchildren's education was funded, providing both a death benefit and a growing cash value they could tap into if needed,” he said. “Another client utilized the cash value of their policy to secure a loan during a financially tight period without the hassle of traditional loan processes.”

Here are a few ways to utilize your cash value policy:

Policy loan: You can take a loan against the cash value of your policy. This allows you to borrow at a nominal interest rate while the cash value in your policy continues to accrue value, effectively lowering your net rate. You can usually only borrow up to a percentage of the total cash value — around 90% or so. Unpaid loan balances reduce your death benefit.

Partial withdrawal: You can make a partial withdrawal (or “surrender”) of the cash value of your policy. This is a tax-free withdrawal as long as the amount is less than your contribution amount to your cash value.  Some policies allow unlimited withdrawals, while others may impose limits on the amount or number of withdrawals on your policy. Any withdrawal over your cash value contribution amount will be taxed as ordinary income.

Premium payment: After your cash value reaches a certain level, you may be able to use some of it to help pay your monthly premiums. Eventually your cash value may earn enough on a monthly basis that you can stop paying premiums out-of-pocket altogether.

Surrender: You may be able to fully surrender your cash value life insurance policy and receive some of the cash value within the policy back. Depending on your policy and when you withdraw your funds you may have to pay a surrender fee of up to 10% of the cash value.