Getting a life insurance policy is typically viewed as a smart money move because it can help give your loved ones financial protection in case you die. But figuring out how life insurance works, including the different types of available policies and their benefits, might not be the easiest to understand.
Here, we explain how cash value life insurance works and what happens to the cash value in a whole life policy at death. This will help you decide whether a life insurance policy with cash value would be the right fit for your financial needs and goals.
What types of life insurance have cash value
Cash value life insurance is among the many types of life insurance policies available from insurers. But this one is different because it has a cash value feature attached.
Basically, with cash value life insurance, a portion of your monthly or annual premiums goes toward funding your life insurance policy, but a portion also gets put into your cash value. Your cash value is typically seen as an investment or savings account feature because it can grow over time. Your cash value can also earn interest, but the way it earns interest depends on your policy.
Many people like the earnings potential of having a cash value feature, as well as the ability to borrow against it with a loan. These benefits could help for retirement savings or having funds available during different types of financial situations, such as helping cover college tuition or paying for home renovations.
Cash value is available only on whole life or permanent life insurance policies, not term life insurance policies. This is just one of a few differences between term vs. whole life insurance.
Cash value vs. face amount
Keep in mind that “cash value” is not the same as “face value” or “face amount.” The face amount of your policy is the amount of life insurance coverage you purchased in case you die.
In other words, it’s the death benefit that’s paid out to your loved ones, known as beneficiaries on your policy, when you die. If you buy a whole life policy with a $500,000 death benefit, your face amount is $500,000.
How the cash value of life insurance works
In many ways, the cash value of your policy acts as an investment account. It can earn interest over time and grow as you pay your life insurance premiums. Your policy could also provide options for policyholders to make withdrawals, including partial withdrawals, and take out loans against the cash value.
Taking out a loan against your cash value is similar to most typical loans. You have to pay back the loan amount and any interest in full. Also, certain withdrawals from your cash value could be taxed if the amount withdrawn is more than what was put in from your premium payments. This could happen because the additional funds are from accrued interest or investment gains versus your initial deposits.
Your cash value account can grow interest in a variety of ways, though it varies by policy and can be impacted by decisions made by you or the company managing the policy. But a major benefit of your cash value growing from interest is that this growth is tax-deferred. That means you wouldn’t be taxed on the interest growth as it occurs, but you would likely be taxed when you withdraw those interest earnings. But because you are not taxed until withdrawal, the interest is considered to grow tax-free.
Here are a few different ways cash value life insurance policies can earn interest:
- Fixed rate: A fixed interest rate is set by your insurer, which determines your cash value growth each year.
- Guaranteed minimum rate: Your insurer invests your cash value amount and sets a guaranteed minimum rate of return on the investment. You typically earn the minimum interest rate set, but if the investments do well, the rate could increase.
- Investments you choose: You choose how you want to invest your cash value, which could include stocks, bonds, and other investments. The rate of growth from interest on your cash value is entirely up to your investment decisions.
- Index fund: The growth of your cash value is tied to an index fund, such as the popular S&P 500. Indexes provide an indirect way to invest in a group of securities, which may include stocks and bonds. For example, the S&P 500 is an index of 500 leading U.S. companies.
What happens to cash value in a whole life policy at death?
You might expect any cash value remaining at your death to be rolled into your death benefit for your beneficiaries. But unfortunately, that’s typically not how it works. In most cases, the cash value in your life insurance policy stays with your insurer at your death. So if you don’t use your cash value while you’re alive, it’s unlikely to benefit you or your loved ones at all when you die.
Conversely, your cash value could have a negative impact on your death benefit if you’re not careful. As mentioned above, the face amount of your insurance policy is how much you’re insured for, or the coverage amount. If you take out a loan on your cash value and die before you pay it and any accumulated interest back, it will likely affect your life insurance face amount.
For example, let’s say you have $500,000 in coverage on your life insurance policy. During your lifetime, you take out a loan of $40,000 against the cash value component of your policy. You pay back $10,000 of the loan, but then you die.
Because you still owe $30,000 on the policy loan, the face value of your death benefit will drop by the same amount plus any accrued interest. In this instance, your beneficiaries would receive a death benefit of $470,000, or the total coverage amount minus how much you still owed on your loan.
The moral of the story is to use your cash value while you’re still alive so it doesn’t go to waste when you die. But it’s also important to keep an eye on your cash value to make sure it’s growing according to your financial plans and goals.
Certain insurance costs, including mortality risk fees, could be regularly taken out of your policy’s cash value. If you’re not paying attention, you could be nearly out of cash value because of your policy’s increasing fees as you age. This might affect your retirement plans if you were hoping to have these extra funds available to cover premium costs or other expenses.
How to get the most out of a cash value life insurance policy
Here are a few tips to help you get the most out of your cash value life insurance policy:
- Use cash value to increase your death benefit. Some insurers will allow you to increase your death benefit with your cash value funds. This could help you get a bigger payout for your beneficiaries and not let your cash value go to waste.
- Cover your policy premiums with cash value. It could make sense to pay your premiums with your cash value if you’ve accumulated enough funds. This could be especially useful during retirement if you’re on a fixed income.
- Surrender your policy in advance of death. If your premium payments and fees continue to increase with age, it might make sense to surrender your policy before your cash value is depleted. Surrendering your policy could mean you receive the cash value you’ve accumulated minus fees and any outstanding loans or premiums. Money received from surrendering your policy is likely subject to ordinary income tax.
- Take out a loan. If you need money and your cash value component has enough funds, it’s possible to take out a loan against it. Just be aware that the loan will likely accrue interest and any unpaid loan amount remaining upon your death will typically subtract from your policy’s death benefit.
- Make a withdrawal. If the value of your cash value component is high enough, you may be able to withdraw from its funds. Any withdrawal that includes money gained from interest or investments will most likely be taxed as income. Also, withdrawals could reduce your death benefit amount.
Does life insurance cash value add to the death benefit?
Life insurance cash value doesn’t typically get added to the death benefit when you die. In most cases, your cash value goes back to the insurer or policy owner after your death. However, if you took a loan out on your cash value and didn’t pay it off before dying, the amount you owe, including interest, could be subtracted from the death benefit paid out to your beneficiaries.
How long does it take for whole life insurance to build cash value?
A whole life insurance policy with a cash value component can typically take 10 years or more to build up any significant amount of value. This is because your cash value grows through your regular premium payments and also potential interest gains. Your interest growth depends on how your cash value is invested, which will affect how quickly it can build. Regardless, it could take a number of years for your cash value to build up significantly.
What is the difference between cash value and surrender value?
The cash value component on some life insurance policies is an amount built up by contributions from a portion of your regular premium payments as well any interest your account accrues. The cash surrender value of your policy is the amount of money you would receive from surrendering, or canceling, your life insurance policy. Typically, the surrender value is how much cash value you’ve built up minus any unpaid loans or premiums, surrender fees, and other potential costs.
Cash value life insurance might make sense for certain situations, but it’s not the easiest type of life insurance to understand. There are simpler types of life insurance available, some of which may not even require a medical exam. In addition, a cash value life insurance policy might not be the best for death benefits or an ideal way to save for retirement.
Before going with this type of policy, do your due diligence and shop around for the best policy to cover your loved ones. Although the cost of insurance is one factor, it isn’t the only thing you want to consider when choosing the smartest policy for you. You can start your search by checking out our list of the best life insurance companies.