Cash value life insurance pays a death benefit to your beneficiaries upon your passing while offering a savings component you can access while you're living. This savings component is funded by a portion of your premium payments. It grows with interest paid by the insurance company. You can access the cash value by taking out a loan on the policy, withdrawing funds, or surrendering (canceling) the policy.
Those simply needing life insurance may be best served with a term life policy, which offers no cash value component. But for someone who needs life insurance and is looking to diversify their investment portfolio, a cash value life insurance policy may be worthy of consideration.
How does cash value life insurance work?
Cash value life insurance is a type of permanent insurance. This means the policy remains in force until your death. Exceptions are if you surrender (cancel) the policy or if the insurance company cancels it due to nonpayment of the premium. This is different from a term life policy, which remains in force for a set term of perhaps 20 or 30 years (with the same exceptions).
When you purchase a cash value policy, you pay the insurance company an annual premium. The insurer then allocates the premium to cover three things: your insurance coverage, your policy’s administrative fees, and your contribution to the policy’s cash value. If you choose, you can increase your cash value contribution by making extra premium payments.
From an insurance perspective, a cash value policy works much like any other life insurance policy. You choose a monetary amount for a death benefit when you buy the policy and designate beneficiaries (for example, your spouse and children). Paying the premium keeps the policy in force. If you die while the policy is in force, your beneficiaries receive the death benefit.
Accessing the policy’s cash value
Money allocated to the cash value component earns interest. How much it earns depends on the type of policy (more about that below). As the cash value grows, you can access it in one of three ways:
- You can make a withdrawal, as from a savings account. Note that any interest earned will be taxable. The insurance company will reduce the death benefit by the amount of the withdrawal.
- You can take out a loan against the cash value. In this case, the insurance company will charge interest on the loan. If you die before repaying the loan, the insurance company will deduct the outstanding amount (including interest) from the death benefit.
- You can surrender the policy. The insurance company will return the cash value to you, minus any premiums owed, outstanding loans, and administrative fees. The policy will no longer be in force.
In some cases, you can use the cash value to pay your premium or increase the amount of your death benefit. Insurers differ in what they may or may not allow you to do.
It's important to note that cash value grows slowly. In the first few years of the policy, most of the premium goes toward insuring you and paying the insurance company's administrative fees. Only a small portion funds the cash value. Over the years, this shifts. But it could take 10 to 15 years before there’s a significant cash value balance. This is one of the caveats of buying a cash value policy and a reason to discuss your financial and insurance needs with a professional advisor.
Types of cash value life insurance policies
There are multiple types of cash value life insurance policies to consider. They include:
A whole life policy offers a fixed premium and fixed death benefit. Unlike with some other life insurance types, the insurer cannot modify the premium based on market conditions or changes to your health. The cash value will accumulate at a guaranteed, though modest, rate.
Indexed universal life
An indexed universal life policy offers a flexible premium and death benefit. This means you can adjust your death benefit (which will affect the amount of premium you owe) as your needs change. The insurance company can also modify your premium or charge fees based on their business needs.
With an indexed universal life policy, your cash value grows based on the performance of a stock index of the insurance company’s choosing. Examples of stock indexes are the Dow Jones Industrial Average (DJIA) and the S&P 500. Your potential earnings may be subject to a cap (maximum) and floor (minimum). While this minimizes your losses in down years for the market, it may also limit your earnings in years the market performs strongly.
Variable universal life
With a variable universal life insurance policy, the cash value is invested in one of up to perhaps 30 investment options presented to you in a prospectus from the insurance company. As with an indexed universal life policy, investment returns may be subject to caps and floors. These policies are typically considered a bit riskier than indexed universal life policies. They’re also subject to higher administrative fees, as they’re considered securities.
A variable universal life insurance policy also offers the option to have the cash value paid out to your beneficiaries (along with the death benefit) upon your death. This option costs extra in premium.
Guaranteed issue whole life
A guaranteed issue life insurance policy offers fast and easy coverage, usually requiring no medical exam. However, the amount of coverage available is much smaller than a standard whole life policy. These are often favored by people who would like some life insurance but cannot qualify for other types of coverage due to their medical condition.
Because guaranteed issue whole life policies offer less coverage than whole or indexed universal life policies, the cash value earnings potential is also smaller.
Advantages and disadvantages of cash value life insurance
When shopping for life insurance, you owe it to yourself to understand the advantages and disadvantages of a cash value policy. Here are a few things to consider.
- The cash value is a living benefit — In addition to providing financial security to your family in the event of your death, a cash value policy provides a source of savings that you can access while you’re living. You can access your cash value for an emergency or other financial need, use it to pay your premium, or increase your death benefit.
- The death benefit is tax-free — As with any life insurance payout, a cash value policy’s death benefit is not taxable. This can help add to your family's financial security.
- The cash value grows tax-deferred — Interest in your cash value accumulates without being taxed. You only pay taxes if you make a withdrawal in an amount above your contribution. And typically, there are no limits to how much you can save each year.
- Cost — Compared to term life insurance (which has no cash value component), cash value policies are more expensive for similar levels of coverage.
- There are likely better savings and investment vehicles available — From an investment perspective, a cash value might make sense for someone looking to diversify their portfolio. However, you may get better returns from a standard investment vehicle, such as a 401(k) or a Roth IRA. In other words, you’d probably want to purchase a cash value policy only if you’re consistently maxing out your contributions to your other investments.
Is cash value life insurance right for you?
Because of its cost, a cash value life policy may not be an ideal purchase for many insurance buyers (those for whom a term life policy would be a better choice). And from an investment perspective, the relatively limited investment returns may make a cash value policy less appealing.
However, if you’ve maxed out the contributions to your other investment vehicles and are looking to diversify your portfolio, cash value life insurance may make sense. The insurance coverage in a cash value policy will also be in force until your death. So if you need coverage for a period longer than what’s available with term life insurance, a cash value policy could be worth considering.
A licensed insurance agent can help you explore your options and decide if a cash value policy is right for you.
Frequently asked questions
What happens when a cash value policy is surrendered?
If you surrender a cash value life insurance policy, you'll receive the cash value minus any premium owed, outstanding loans, and administrative fees. Surrendering also means you're canceling the coverage, so your beneficiaries will no longer be eligible to receive a death benefit upon your passing.
What happens to the cash value when the policyholder dies?
If the policyholder dies with a cash value balance, that balance is typically kept by the insurance company. The policyholder’s beneficiaries receive a death benefit payment.
How long does it take to build cash value in a life insurance policy?
It can take 10 to 15 years, or longer, to build up significant cash value. The reason is that in the early years of a cash value policy, the insurer typically puts a high portion of your premium payment toward insuring you. A portion goes to administrative fees as well. That leaves only a small amount of money to be allocated to the cash value. The allocation eventually becomes more balanced, but that process can take decades!
Are there any tax advantages of a cash value life insurance policy?
Yes, cash value life insurance offers some tax advantages. First, as with any life insurance policy, the death benefit is paid tax-free. This means your beneficiaries avoid a big tax bill associated with their payout. Secondly, the cash value grows on a tax-deferred basis. You won’t have to worry about paying taxes until you access that money. Finally, money borrowed or withdrawn from a cash value policy is not subject to taxes up to the “cost basis.” This means you’ll only be taxed for money the policy earns through investments and interest payments.
Cash value life insurance provides both financial protection and savings
A cash value policy provides both life insurance to keep your family financially secure and a savings component that you can access while you're living. This type of policy isn't right for everyone. Still, if you need life insurance and have an opportunity to diversify your investment portfolio, cash value might be right for you.