We all love cash value, so it seems like a no-brainer to have cash value life insurance. Well, let's talk through it. Even though getting life insurance is important, a cash value policy may not be what you expect. It’s likely a lot more expensive than you thought, too.
In this article, we'll go over what cash value life insurance is, how it works, and the different types. Our goal is to help you understand it so you can make the best life insurance decision for yourself!
What is cash value life insurance?
Cash value life insurance is more than insurance. It’s life insurance with a savings account attached to it. A portion of your premium covers the death benefit (the amount your loved ones receive if you die), and the other part goes into the savings vehicle. Most cash value insurance policies are permanent policies, which means that they last for your lifetime or as long as you pay the premiums.
How cash value life insurance works
Most cash value policies have a premium payment. This is the amount you pay to cover the death benefit. If you pay these premiums on time, your loved ones receive the death benefit when you die. The cash value portion is the savings vehicle. Any money beyond the level of premium payment is invested in the cash value. Depending on the policy type, it earns interest, or you may invest it in particular assets e.g. stock market funds.
Either way, the value grows over time, or that’s the intent. The cash value decreases the insurance company’s risk because they use the money to offset the death benefit when they pay it out. But, you may use the cash value for other purposes.
Types of cash value life insurance
You have a few options when choosing a cash value life insurance policy. Knowing the features of each can help you decide.
Whole life insurance
A whole life policy lasts for your entire life. It has the same premium and death benefit for the policy’s life, and the insurance company sets a set rate of return on the cash value. Most policyholders earn around 2% on their cash value.
Universal life insurance
A universal life insurance policy is more complicated because you have flexibility with the premiums and coverage amounts. As long as you cover the minimum premium for the death benefit, you can pay more or just the minimum amount each month. If you have extra money, you can pay it toward your universal policy and invest it in the cash value. You can also have your premiums deducted from the cash value when your cash value reaches a certain point.
Variable life insurance
If you want more than a ‘savings account’ for your life insurance’s cash portion, variable life offers investment options, such as stocks and bonds. It’s riskier because there’s no guarantee your cash value will appreciate (it may decrease). But the reward is often much more significant.
Cash value vs. term life insurance
Cash value life insurance is not the same as term life insurance. They have the same premise - a death benefit that pays your loved ones when you die, but that’s it.
Term life insurance doesn’t have a cash value. It’s also only applicable for a specified period. For example, a 10-year term policy expires after ten years. If you’re alive (that’s a good thing), the policy expires. Some insurance companies allow you to convert it to a permanent policy or renew the term. You may need to qualify, a.k.a. have a medical exam and undergo underwriting, which will likely increase your rates for your older age if nothing else.
Pros vs. cons of cash value life insurance
Every life insurance policy has many benefits and downsides. Understanding both sides helps you choose the right policy.
- It lasts for your lifetime. As long as you pay your premiums, your beneficiaries will receive what’s left of your death benefit.
- You may use the cash value to cover your premiums after years of paying premiums.
- You can borrow from the cash value and/or withdraw funds from it to use while you’re alive.
- The money grows tax-deferred. You don’t incur a tax liability until you withdraw the earnings.
- The premiums on a cash value life insurance policy are much higher than term life insurance policies.
- The fees are excessive. You may find less costly ways to invest the extra money you pay toward your life insurance.
- Cash value policies are often hard to understand. Some people buy them without fully understanding what they’re buying or investing in.
Who should and shouldn’t apply for cash value life insurance?
Like any financial decision, whether cash value life insurance is right for you or not depends on your situation. Young families usually stick with term life insurance policies. They are predictable and cover families when they have the least money available for a crisis, such as death. A term policy can cover events such as a mortgage, children going to college, or providing a surviving spouse with income.
Cash value policies are more expensive, but they provide another outlet for investing. If you’ve maxed out your retirement contributions in your 401K and/or IRA, a cash value policy may make sense. You should also make sure you’re secure in all other areas of your life. Do you have an emergency fund? Have you paid off all consumer debt? If you have disposable income you’re looking to invest, then a cash value policy may make sense.
5 ways to access your cash value life insurance
You can’t walk up to an ATM and withdraw the cash value of your life insurance policy. You may only access the cash in one of these five ways:
1. Take out a loan against the cash value
Once you accumulate a cash value, you can take out a loan. The insurance company determines the terms, and yes, you’ll pay interest. Even though you pay this interest to yourself, it’s still a cost. If you don’t pay the loan back, the insurance company decreases the death benefit dollar-for-dollar when you die.
2. Make a partial withdrawal
While you can’t get the money from an ATM, you can partially withdraw some of your policy’s cash value. This leaves your policy intact but decreases the total death benefit dollar-for-dollar. For example, if you have a $100,000 policy and withdraw $10,000 from your cash value, your loved ones get $90,000 rather than $100,000 when you die.
3. Surrender the policy
If you’ve decided you no longer want the policy, you can surrender it. You receive the cash value, minus fees and taxes, and the policy ends. Your loved ones no longer have a death benefit, but you also don’t have to pay premiums any longer.
4. Sell your policy for a life insurance settlement
Some brokers offer a life insurance settlement, which means they offer to settle your life insurance for a lesser amount. If your policy is worth $100,000, they’ll offer a payoff that’s less than $100,000. Settling may provide you with more than surrendering the policy, but if you settle for more than the total premiums paid, you’ll owe taxes on the capital gains.
5. Pay the premium with the cash value
If your cash value is high enough, you may use the cash to pay your premiums on your permanent life insurance policy.
What can you do with the cash?
The cash is yours to do what you want. The life insurance company doesn’t tell you how to use it or approve your intended use. Remember, when you take the cash, you decrease or surrender the death benefit. If you intended to leave your loved ones with a legacy, support a loved one financially, or want to help your family with your estate costs, invest the cash somewhere. They’ll be able to access it when you die.
Is a cash value life insurance policy a good choice?
A cash value life insurance policy has its benefits, but only in certain situations. If you haven't maxed out your tax-advantaged retirement or you still have debts, investing your money in those areas may provide a greater return on your investment.
If you want a policy that forces you to save or need somewhere else to invest money to use in retirement or leave for your loved ones, talk with a financial advisor about your options and see which cash value life insurance policy may be right for you.