At its most basic level, a life insurance policy is financial protection for your loved ones. Paying your monthly premiums keeps your policy active. If you die with an active policy, your life insurance will typically pay out a death benefit to your beneficiaries — the people you’ve assigned to receive the payout.
Cash value life insurance is among the many types of life insurance. It involves these same principles but adds a cash value feature to your policy. This is often viewed as an investing or savings feature and could be beneficial in certain situations.
In this guide, you’ll learn about how cash value life insurance works. This will help you understand the pros and cons of this type of life insurance and whether it would be the right fit for you and your financial situation.
What is cash value life insurance?
Life insurance is typically separated into two categories: term vs. whole life insurance. Whole life insurance is often categorized as permanent life insurance as well.
- Term life insurance typically lasts for a certain number of years, called a term, and then expires. If you die within the term, your policy will pay out the death benefit. If you die after the term ends, there is typically no death benefit. Terms may last between one and 30 years or more.
- Permanent life insurance lasts your whole life, so there’s no worry of your policy expiring after a certain period of time. The policy won’t end until you cancel it, default on your payments, or die.
Cash value life insurance is a type of permanent life insurance policy that offers lifelong coverage and includes an investment feature, called the policy’s cash value. The money in the policy’s cash value account can grow over time as you pay your premiums and if any interest is earned. As the policyholder, you might have the option to withdraw from your policy’s cash value, including partial withdrawal amounts, or borrow against it as a loan.
How cash value life insurance works
If you know how life insurance works, you’re already partway to understanding how cash value life insurance works.
Certain details of cash value life insurance policies will likely vary depending on the insurer, but the gist is often the same — you get a cash value component as part of your policy. Also, your policy will likely have higher premiums than a term life insurance policy because permanent life insurance is generally more expensive since it covers you for your whole life.
Your cash value typically grows as you pay your premiums. A portion of your premiums goes toward your cash value and a portion goes toward the cost of your policy. Your cash value can also grow by accruing interest.
How the cash value of your policy grows depends on your particular life insurance policy and how the money is invested. But any interest accrued on the cash value portion is typically tax-deferred. This means you won’t be taxed as interest is accrued and added to your cash value, but you will be subject to taxation when you withdraw that money. This tax-free growth and the ability to control when you’re taxed are among the reasons some people find this kind of life insurance to be an appealing form of investing.
But keep in mind that you can typically only use your cash value while you’re still alive. If you die and haven’t used your cash value, it’s not likely to be included in the death benefit your beneficiaries receive.
Here are a few common types of cash value life insurance policies and how they accrue interest:
- Whole life insurance: The cash value earns a fixed rate of interest set by your life insurance provider. If you receive dividends from your insurance company, you may be able to apply them to your cash value for faster growth.
- Universal life insurance: Your insurer sets a guaranteed minimum interest rate on your money, which can go up if your investments do well.
- Variable universal life insurance: Your cash value’s interest growth is tied to different investments that you choose. Variable life insurance investment options might include stocks or bonds.
- Indexed universal life insurance: Your cash value’s interest growth is tied to an index, which is a type of mutual fund or exchange-traded fund (ETF) that tracks the returns of a particular market index. The S&P 500 is an example of a popular index fund that includes 500 leading U.S. companies.
Taxes and cash value life insurance
To determine when life insurance is taxable, it’s important to clarify which type of policy you have. Cash value life insurance policies are permanent policies with a cash value feature attached. These types of policies can provide the policy owner with tax benefits, but you also might owe taxes depending on the actions you take.
As mentioned above, if your cash value policy accrues interest, that interest is typically tax-deferred, so you don’t have to pay taxes as the cash value grows. It may also become tax-exempt, which means you wouldn’t owe any taxes if the cash value is included in the death benefit of your policy.
However, most people buy into a cash value policy because it allows you to withdraw from the cash value, take a policy loan out against the cash value, or surrender (cancel) your policy and receive the cash value. Here are some details to be aware of before you take advantage of these features:
- If you take out a loan against your cash value, you’ll have to pay the loan back, often with interest. And if you die while you have an outstanding loan balance, the amount you owe will likely be taken out of your death benefit.
- If you withdraw funds from your cash value above the amount that came from your premium payments, the additional amount may be subject to income tax. That’s because this additional amount would likely be from interest or investment gains.
- If you surrender your policy, you’ll lose your death benefit, probably have to pay surrender fees, and could be charged income tax on any money you receive from surrendering the policy.
Your loved ones don’t typically have to worry about paying taxes on your life insurance policy’s death benefit if it’s paid out in a lump sum, or all at once. But if your death benefit is paid out in increments, then it might earn interest over time while the money is waiting to be paid out. Any interest earned in this way could be counted as taxable income.
Pros and cons of cash value life insurance
For a quick overview, check out these pros and cons of cash value life insurance:
- Lifelong coverage: As a type of permanent life insurance, your cash value life insurance policy will last your entire life.
- Loans and withdrawals: You’re able to withdraw money or take out loans against your cash value, typically once it has grown enough. This can be helpful if you need money for another financial situation.
- Tax-deferred interest earnings: Any interest your cash value accrues is tax-deferred, making it easier for you to grow your cash value over time since the full amount is growing without taxes being regularly taken out.
- Could cover premiums: If you have enough cash value, you could use it to cover your policy’s premiums and have your insurance pay for itself.
- Long time to grow: It can take years for your cash value to grow, so it likely wouldn’t make sense to start with one of these policies later in life when you won’t have sufficient time to take advantage of the cash value growth.
- Surrender fees: You typically have to pay surrender fees if you surrender your policy. This can cut into any amount of money you would receive from the surrender value.
- Decreased death benefit: If your policy’s death benefit is partly tied to the policy’s cash value, any withdrawals from your cash value could reduce the amount paid out by the death benefit.
- High costs and other fees: Permanent life insurance is often more expensive than term life insurance. You also might have to pay certain fees, like administration fees, fund management fees, or a mortality and expense charge if you don’t live to an estimated age.
- Can be confusing: It can be difficult to understand how cash value works, as well as when you would and wouldn’t be taxed.
Is cash value life insurance right for you?
Cash value life insurance is often seen as more complicated than term life insurance because of the cash value feature. Knowing how long to build your cash value, how to invest it, and when to use it might require additional financial guidance. Additionally, certain situations might not make the most sense for a cash value policy.
For example, if you’re already close to retirement, you likely won’t have a sufficient amount of time to build your cash value by the time you need it. Also, other retirement accounts might offer a better rate of return on your investment. But if you’ve already maxed out your other investments, a cash value life insurance policy could make sense as a retirement vehicle.
Before committing to a cash value life insurance policy, do some comparison shopping to explore your options. This could help you better understand how different types of life insurance policies work and which ones might make sense for your unique situation. It can also give you an idea of the variations in the cost of insurance policies. You can get started by learning about our top picks for the best life insurance companies.
It’s also important to have an understanding of how much life insurance you need. A common method for determining a suitable amount of life insurance coverage is to multiply your annual income by 10. But if you dig deeper than this rule of thumb, you’ll likely have a better and more accurate estimate of how much life insurance you need.
Consider all the potential future expenses and financial obligations that would remain if you were to die. This could include your home’s mortgage, replacing lost income for a certain number of years, paying for college, and taking care of everyday expenses like groceries and utilities. If you add everything together, you should have a good idea of your life insurance needs.
Is life insurance with a cash value worth it?
Cash value life insurance is worth it if it makes sense for your financial situation and goals. Getting this type of life insurance is typically a better idea when you’re young so you can have enough time to allow your cash value to grow. A cash value policy could also be the right fit if you want an option for withdrawing funds or taking a loan out against your policy if you need it.
How long does it take for whole life insurance to build cash value?
It can take years for a whole life insurance policy to build cash value. Though this can depend on how much you’re paying in premiums, if your cash value earns interest, and how much (if any) interest your cash value earns. It’s often recommended to wait 10 years or more for your cash value to grow before dipping into its funds.
What happens when a life insurance policy is surrendered for cash value?
Surrendering your life insurance policy for its cash value will essentially cancel your policy. This means you won’t have a death benefit anymore. But you could receive money based on how much has been contributed to the policy’s cash value. Keep in mind that you may have to pay surrender fees and any unpaid loans or unpaid premiums could be subtracted from your potential payout. The money you receive from surrendering a policy could also be subject to income tax.
Cash value life insurance makes sense for certain situations, but it might not be the right fit for everyone. It’s important to allow plenty of time for your cash value to grow so you can take advantage of these tax-deferred funds when you need them, like during retirement. But if you’re already nearing retirement, you likely don’t have the time needed to properly grow a cash value policy.
For many people, term life insurance policies are the most popular. They’re typically less expensive and often straightforward and easy to understand. You get life insurance for a set number of years and, if you die during those years, a death benefit is paid out to your loved ones. This type of policy can suit many financial situations, but it’s still best to do comparison shopping to see what aligns with your goals.