How Does Cash Value Life Insurance Work?

We all love cash value, so it seems like a no-brainer to have cash value life insurance. But how does cash value life insurance work, and is it a good idea? Get a better understanding of this type of life insurance and whether it’s the best choice for you or not.

Cash value life insurance

Well, let’s talk through it. Even though the importance of life insurance cannot be overstated, 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 and how it works. We’ll also explore cash value life insurance pros and cons.

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?

It’s more than basic life insurance coverage. It’s a type of life insurance policy with a savings account attached to it, called the cash value component. As you pay premiums, you fill your cash value account.

Most cash value insurance policies are permanent life insurance. Permanent insurance means the policy lasts for your lifetime or as long as you pay the premiums.

How does cash value life insurance work?

In general, cash value policies work like any other life insurance policy. You pay a premium to the insurance company. In exchange, your loved ones receive the death benefit payout from the life insurance company when you die.

In addition, it allows you to save in a cash value account. The insurance company deposits a portion of your premium payments into your cash value account.

Whether through interest or investments, the hope is that your cash value will grow over time, which can be a motivation for saving money. The cash value decreases the insurance company’s risk because they use the money to offset the death benefit when they pay it out.

Or, you can use the cash value as extra cash savings for yourself.

How you build cash value

Insurance companies use your premium payments for three things:

  • The cost of guaranteeing the death benefit.
  • Administrative costs of the insurance company.
  • Your cash value account.

You only receive a portion of your premium amount in your cash value account. The exact portion of your premium that goes toward cash value will vary depending on the type of policy you have.

How your cash value grows

Cash value grows differently for different types of permanent policies.

In addition to your premium contributions, your cash value account might grow in a few ways:

  • Interest earnings from fixed interest rates
  • Interest earnings tied to an index
  • Earnings from investments in securities

The amount you can earn in a cash value life insurance varies based on a few factors, most importantly, what type of policy you choose.

Modified endowment contracts (MEC)

Surprisingly, you can put too much money into your cash value account. Overfunding your cash value account above legal tax limits turns your policy into a modified endowment contract, or MEC.

A MEC still works like life insurance on the insurance side—your beneficiaries will receive the death benefit when you die.

However, MECs come with tax implications. While you receive tax benefits from cash value life insurance, MECs do not.

Once the IRS relabels your policy as an MEC, there’s no way to convert it back to regular life insurance.

Types of cash value life insurance

You have a few options when choosing an insurance policy. Knowing the features of each can help you decide.

Whole life insurance

What about a term vs whole life insurance policy? A whole life insurance policy is different from a term policy in that it lasts your entire life.

It has the same premium for the policy’s life, and the insurance company sets a set rate of return on the cash value. Most policyholders earn around 1.5% for guaranteed cash value, claims Consumer Reports.

Universal life insurance

Universal life policies are more complicated than whole life 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.

Expert tip: Use the cash you earn

Your beneficiaries typically won’t get any cash value left in your policy when you pass away. As you get older, you might want to use more of your cash value so less goes back to the insurance company.

Whatever you do, make these funds part of your financial planning process so you know what you’re going to do with the money.

Cash value life insurance versus 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 and will lapse after a certain timeframe.

For example, a 10-year term policy expires after ten years. If you’re alive (that’s a good thing), the policy expires.

Finding the best term life insurance is great if you want coverage without a lot of expense, but it doesn’t grow your savings.

Some insurance companies allow you to convert it to a permanent policy or renew the term. You’ll also likely pay more for coverage, though.

Pros and cons

There are benefits of life insurance with cash value and downsides. Understanding both sides helps you choose the right policy.

Let’s take a closer look at cash value life insurance pros and cons to see if it’s right for you.

Pros of cash value life insurance

  • It lasts for your lifetime. As long as you pay your premiums, your beneficiaries will receive the insurance’s 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.

Cons of cash value life insurance

  • The premiums on a cash value life insurance policy are much higher than term life insurance policies.
  • The fees can be high. 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 this 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 financial 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. It leaves your policy intact but decreases the total death benefit.

3. Surrender the policy

If you’ve decided you no longer want the policy, you can surrender it. You receive the cash value, and the policy ends.

However, you won’t get the full amount of your cash value account. The actual amount you’ll receive is called the cash surrender value. The surrender value is your cash value balance minus taxes or fees.

Most insurance companies charge surrender fees to cancel policies before your death. You’ll also need to cover any income tax liabilities incurred from withdrawing earnings.

Your loved ones no longer have a death benefit, but you also don’t have to pay premiums.

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. You may find this helpful if you’re struggling financially.

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 intend 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.

What life insurance is best for cash value?

Any permanent life insurance policy that has a cash value component can help you build savings.

In general, whole life policies tend to grow slower than universal life or variable life policies due to the fixed interest earnings.

The best earning potential comes from a variable life insurance policy.

However, your money is not guaranteed in a variable life policy and could lose value.

Is cash value whole life insurance worth it?

Whole life insurance could be worth it, depending on your life insurance goals. A whole life policy is often expensive.

But, whole life coverage generally guarantees your cash value earnings thanks to fixed interest rates. If you’re looking for guaranteed growth of your cash value savings, whole life might be worth it.

Can you cash out your cash value life insurance policy?

Yes, there are a couple of ways to cash out your life insurance policy. The first is to take a loan against your cash value balance. You’ll pay interest on the loan, and if you don’t pay it back before your death, the insurance company will decrease your death benefit.

You may also withdraw cash from the account, which also lowers the death benefit. Finally, you can surrender your policy.

However, this means your policy is no longer in effect, and you’ll generally have to pay a surrender fee and taxes on the money.

If you found this article informative, you’ll love reading these other posts about various types of life insurance!

Cash value life policies are worth considering but you should think about all your options

A cash value 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.

You may wonder, “Do I need a financial advisor?” Consider talking with one about your options (and understand how does cash value life insurance work) before finding a policy. They can help you better understand your options and get life insurance quotes to meet your needs.

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