An alternative to term life insurance that comes with a investment-style savings component.
Most life insurance shoppers choose between term and permanent life insurance. This decision is made primarily on how long they want the policy to last, but they’re also making a decision on if they want a cash value life insurance policy.
Cash value life insurance is a type of insurance that comes with an investment-like component that gains value over the life of the policy, can be borrowed against like a loan, and is paid out upon the policyholder’s death.
Cash values are components of permanent life insurance policies. These include:
Term life insurance differs from these in that it only has a death benefit and doesn’t include a cash value. Term life insurance also ends after a set amount of time (the term) while permanent policies stay in effect as long as the premiums are paid.
These two factors make term life insurance considerably more affordable than permanent policies; while term life is the best option for most people, others may benefit from the versatility afforded by the cash value component of permanent policies.
Learn more about the difference between a term and permanent life insurance policy.
Initially, cash value life insurance works the same as term: The policyholder makes regular payments called premiums to keep the policy active. If the policyholder dies, any beneficiaries receive an agreed-upon amount of money called the death benefit.
Behind the scenes, things are different. Instead of premium payments going exclusively toward the insurance policy, they’re split between funding the death benefit and funding the cash value. Over time, the savings component provided by the policy grows and the death benefit shrinks; if the policyholder dies after the cash value of the policy is fully realized, the entire amount paid comes from the cash value rather than the death benefit.
The cash value works differently depending on the type of policy you have. Whole life offers a guaranteed cash value growth and dividends. The cash value of variable insurance isn’t guaranteed if your investments underperform, and the cash value of a universal life policy is protected from risk but can be depleted if it’s accessed to pay the policy premiums (explained below); neither offers dividends.
Additionally, how the cash value grows depends on the policy type. Whole life insurance works like a savings account and earns interest at a predetermined rate. With variable life insurance the money is invested in a series of in-house mutual fund-like sub-accounts and its performance reflects broader market trends. A universal policy’s cash value grows at the interest rate of a predetermined index (like the S&P 500) chosen by the life insurance company. Some insurance companies may also offer variable universal policies in which the policyholder can alter the premium and death benefit while also investing the cash value in sub-accounts.
|Whole Life Insurance||Variable Life Insurance||Universal Life Insurance|
|Guaranteed Death Benefit?||Yes||Yes||Yes|
|Guaranteed Cash Value?||Yes||No||Protected from risk, but can be depleted to pay premiums|
|How Cash Grows (or Shrinks)||Earns interest at pre-determined rate||Sub-accounts - pool of investor funds offered by insurer||Fixed interest rate|
|Premiums||Level||Level||Varies, up to the customer (subject to federal tax laws)|
|Notes||No risk compared to other permanent types, but there may be better investment options||Risk of holding expensive insurance policy with little to no cash value||-|
Because the cash value component of a life insurance policy is essentially an investment, you can do many of the same things you can with a traditional investment vehicle, like withdraw money from it. Depending on the cash value amount and the type of life insurance involved, policyholders can:
You can use cash value life insurance policy as a loan. This isn’t the same as making withdrawals from it; you’re borrowing against your policy. As with other loans, a cash value loan accrues interest until you pay it back. If you die before you pay it back, the amount you owe will be deducted from your death benefit.
Life insurance policies often offer lower interest rates than you’d get elsewhere, which makes them enticing. However, considering the impact it can have on your policy and beneficiaries, you should always consider whether you need a loan or if you should just save for something.
Once you’ve built up enough of a cash value, you can use it to fund your life insurance policy, using the built-up value to pay your premiums.
That can be handy, as a permanent life insurance policy tends to cost more than comparable term life policies. If you can get a few months (or more) of relief from paying for the policy, you’ll keep it in force and avoid surrender. There are usually limits to this; it can only be done after the first year of policy ownership, and there typically needs to be enough cash to fund the policy for at least 60 days.
You can also use dividends paid out by the policy to increase the death benefit. You are, essentially, buying more, smaller amounts of insurance to add to your policy. You may be subject to further underwriting or fees to increase or decrease the death benefit.
When you retire, make sure you can rely on the savings accounts you have in place, like an individual retirement account or a 401(k); these should still be the primary way you fund your retirement. But whole life insurance can be a worthy supplement. Many financial experts tout the “4% rule” for retirement savings: You use 4% of your savings in each year of your retirement.
With a cash value life insurance policy, you can access the built-up savings component instead of dipping into your savings. This allows you to be strategic about your retirement spending. For example, after a down year in the market, you can use the cash value of a policy instead of your IRA, allowing your savings to replenish. When you make withdrawals from your policy, they’re generally free of income tax, and you can withdraw up to the total in premiums paid.
But take into account what type of cash value policy you have; whole life is more likely to grow at a steady rate, while variable life insurance can be less insulated from market downturns.
If you want to access the cash accumulation — and, more importantly, don’t want life insurance anymore — you can surrender your insurance policy and receive money equal to the cash surrender value.
However, there are a few key things you should know when you do:
Anyone considering taking action with the cash value of a life insurance policy should talk to a licensed life insurance agent or a financial adviser. They can let you know the implications of doing so and any alternatives available to you so you don’t make a mistake that costs you your savings and your insurance.
For many people, a straightforward term life policy will be enough. But a cash value policy may be helpful in a few scenarios.
The first consideration should always be whether or not you can afford the policy. Cash value policies are more expensive than comparable term insurance, and many are dropped prematurely or don’t provide a proper level of coverage.
Permanent life insurance can be helpful for people with high-income earners with complex finances. The cash value component is useful in covering debts so the majority of your assets go to beneficiaries.
If you’ve maxed out your other investment accounts, like a 401(k) and IRA, a cash value life insurance policy is useful for another avenue for saving money. Additionally, anyone who needs a leg up in investing might be well-served by these policies, as they act as a “forced” savings vehicle.
Finally, those who want the level of flexibility cash value policies afford may want to look into them. This is more complicated than most life insurance owners need, but it can be a useful option if available.