Q

What is cash value life insurance?

A

Cash value life insurance refers to any type of permanent life insurance that comes with an investment-style savings component.

Jennifer Pan

Jennifer Pan

Published November 18, 2019

KEY TAKEAWAYS

  • Cash value life insurance, also known as permanent life insurance, doesn’t expire and comes with a tax-deferred savings component

  • Cash value life insurance policies typically cost 6 to 10 times more than term life insurance for the same death benefit amount

  • Because cash value life insurance is more expensive and more complicated than term life insurance, it isn’t recommended for most people

  • Cash value policies usually come with limited investment options and relatively low rates of return

When you shop for a life insurance policy, one of the first decisions you’ll need to make is whether to buy term life insurance or permanent life insurance. Term life, which is affordable and straightforward, is the right choice for most people. A term life policy lasts for a set period, usually between 10 to 30 years, then expires.

Permanent life insurance, on the other hand, lasts your entire life and usually also has a cash value component. The cash value works like an investment or savings account and grows tax-deferred over the life of the policy. Any type of life insurance that offers this feature is cash value life insurance.

A policy’s cash value can be withdrawn, used to take out a loan, and, in some cases, used to pay the policy’s premiums. But cash value life insurance also comes with certain risks.

In this article:

How does cash value life insurance work?

The death benefit of a cash value life insurance policy works the same way as it does with term life insurance: The policyholder pays either a monthly or annual premium to keep the policy active. If the policyholder dies, any beneficiaries receive the death benefit, usually a tax-free lump sum of money.

But with a cash value policy, when you pay the premium, a certain percentage also goes into a tax-deferred savings component, known as the cash value of the policy. (The exact amount that goes into savings is determined by your individual policy.) The cash value grows over time.

There are several different types of cash value life insurance, and each accrues cash value differently. Here’s how a few of the most common types of policies work:

  • Whole life insurance cash value earns interest at a rate set by the insurer. Mutual insurance companies also pay dividends.

  • Variable universal life insurance cash value is invested in sub-accounts offered by insurer that work much like mutual funds. The performance of the cash value is based on the returns of those sub-accounts.

  • Indexed universal life insurance cash value is invested in a stock market index (such as the S&P 500) selected by the insurer. Most policies have both an interest rate floor and ceiling, meaning that the cash value growth won’t go below or above a certain range.

  • Guaranteed universal life insurance has minimal to no cash value accumulation.

Not sure if cash value insurance is right for you? Check out our explainer on the different types of life insurance.

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What can you do with the cash value of a life insurance policy?

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 (such as a mutual fund or IRA) including withdraw money from it.

Depending on the cash value amount and the type of life insurance involved, policyholders can also:

Take out a loan

When you take out a loan against your cash value life insurance policy, you’re borrowing against the policy, not simply withdrawing from it. 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 (including interest) 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 your beneficiaries, you should always consider whether you absolutely need the loan, or if you could get by with saving instead.

Learn more about different types of loans, including how to apply for one online.

Use it on the policy

Once you’ve built up enough cash value, some types of cash value life insurance, such as universal life insurance, allow you to use the cash value to pay your premiums.

That can be handy, as cash value life insurance generally costs 6 to 10 times more than comparable term life policies. If you’re struggling to pay your premiums and you can get a few months (or more) of relief from paying for the policy, you’ll keep it in force and avoid surrender.

But there are limits to this: You can only use your policy’s cash value to pay premiums after the first year of owning the policy, and there typically needs to be enough cash value built up to fund the policy for at least 60 days. Furthermore, if you end up depleting the entirety of the cash value to pay your premiums, your policy will lapse.

Supplement retirement savings

Dedicated retirement accounts such as a 401(k) or Roth IRA should be the primary way you fund your retirement. But cash value life insurance can sometimes be a useful supplement.

Many financial experts tout the “4% rule” for retirement savings: You should plan to use 4% of your savings in each year of your retirement. With a cash value life insurance policy, you can access the cash value 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 withdraw from your policy’s cash value rather than from your IRA, allowing your IRA savings to replenish.

However, keep in mind that the cash value of many types of permanent insurance, such as variable universal life insurance, will also be vulnerable to market fluctuations.

Surrender the policy and take the cash

If you want your policy’s entire cash value — and, more importantly, you don’t need life insurance anymore — you can surrender your insurance policy and receive money equal to the cash surrender value.

However, there are a few important things to know before doing this:

  • If you surrender the policy during the surrender period — usually the first two to three years of owning it — you may not get any of the cash value, or you may be subject to steep fees. Even during the first 10 or so years, you may still have to pay surrender charges.
  • You won’t have a life insurance policy anymore, and that means that your beneficiaries won’t receive a death benefit if you die. Have a plan in place when you surrender a policy, whether it’s buying a term life policy or being self-insured.
  • The surrender value is subject to taxation. Any money you receive over the basis (that is, the part of your cash value that’s drawn from your premiums) can be taxed as income. Learn more about life insurance and taxes.

Anyone considering surrendering a life insurance policy should talk to a licensed life insurance agent or a financial adviser. They can walk you through the process and let you know about any available alternatives so you don’t make a mistake that costs you your savings and your life insurance.

Drawbacks of cash value life insurance

A term life policy, which is meant to protect your dependents for the time period when they rely on your income, is sufficient for most people. That’s because as you age, your financial obligations — such as paying off a mortgage or supporting children — usually decrease and you stop needing life insurance coverage.

While a cash value policy does make sense for some people, there are several drawbacks to cash value insurance that all shoppers should consider:

It takes a long time to build up the cash value

Most of the growth in your policy’s cash value happens when you’ve held the policy for two or three decades. If you surrender your policy within the first 10 years, it’s unlikely that your cash value will be greater than the total premiums you have paid.

It’s expensive

Cash value life insurance policies, such as whole life, typically cost 6 to 10 times more than term life insurance for the same death benefit amount.

Take a look at the table below, which compares the monthly cost of a 20-year term policy (with a $250,000 death benefit) to the monthly cost of a whole life policy (with a $100,000 death benefit) for a healthy male at different ages:

AgeTerm ($250,000)Whole ($100,000)
20$15.90$85.45
30$16.14$122.20
40$21.75$196.25
50$47.86$233.94

Note that the term policy provides more than twice the death benefit amount that the whole life policy does for a fraction of the cost.

According to one study, about 45% of people who purchase whole life insurance surrender their policies within the first 10 years due to the high cost of premiums. Permanent life insurance won’t do you or your beneficiaries much good if your policy lapses, and common financial setbacks like unemployment or medical emergencies can affect your ability to pay high premiums.

Read our full analysis of the pros and cons of term vs whole life policies.

Cash value isn’t added to your death benefit

The cash value of a policy is separate from the death benefit. While your beneficiaries are guaranteed to receive the death benefit when you die (provided you’ve paid your premiums), the cash value component can only be utilized while you are living.

This can be confusing to shoppers who believe that in the event of their death, their beneficiaries will receive both the death benefit and the accrued cash value. However, anything that remains of your policy’s cash value when you die will be retained by the insurance company.

There are better ways to invest

Cash value comes with limited investment options and relatively low rates of return. Over the long run, dedicated investment options, such as a 401(k) or IRA, will likely provide better returns than a permanent life insurance policy. The long-term rate of return on a whole life policy is usually around 3 to 4%, while the rates of return on alternative investments average much higher.

Who should consider cash value life insurance?

Though term life is sufficient for most people, a permanent life insurance policy with cash value may be useful in a few scenarios.

The first consideration should always be whether or not you can afford the policy. Because cash value policies cost much more than comparable term insurance, many are dropped prematurely or don’t provide a proper level of coverage.

Cash value life insurance policies can make sense for people with complex financial needs, including:

  • High-income earners who have already maxed out their other retirement accounts, such as their 401(k) and Roth IRA, and are seeking an additional vehicle for tax-deferred savings.
  • People whose children have special needs or who have other lifelong dependents.
  • High net-worth individuals who are looking to build a tax-free inheritance for their children or offset the costs of an estate tax on their assets.

Learn more about the difference between term and permanent life insurance.