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Insurance Life Insurance

How Cash Value Life Insurance Works

Updated Apr 05, 2023   |   8-min read

For many people, the best life insurance companies can provide protection for your loved ones in the event that the worst-case scenario happens. It will pay a cash benefit when you die, based on the conditions of the policy. There are two main types of life insurance policies: term life and permanent life insurance. Permanent life insurance policies offer a cash value component.

Cash value life insurance policies provide life insurance along with an investment. A portion of the premium is paid into an investment account, which accrues interest over time. While this might sound like an attractive option, cash value life insurance policies can have some notable disadvantages. Understanding how they work is critical to making an informed decision about whether they are the right choice for you.

What is Cash Value Life Insurance?

A cash value life insurance policy is any life insurance policy that includes both a death benefit and accumulated funds. With a cash value life insurance policy, every time you make a monthly payment, some of the money goes toward insurance costs, fees, and the cash value account. This allows the policyholder to build up value within the cash value account over time. This amount grows tax-deferred over time

However, that cash value won’t be paid with the death benefit. That means if an insured person dies, his or her beneficiaries will not receive the cash value. Any value that is left in the policy when the insured dies goes to the insurer. However, the policy can be cashed out before the insured person’s death. It can also be used as collateral for a loan.

In the first few years of a cash value life insurance policy, the majority of premiums go toward the cost of insurance and fees. It can take years for the compound interest of the cash value to grow significantly. This makes cash value life insurance policies less favorable for older purchasers, as they likely would not have enough time to accumulate funds in their cash value account.

>> Read More: Best life insurance for seniors

Common Cash Value Life Insurance Policies

As a general rule, a cash value life insurance policy is permanent, which means that insured people have coverage for their entire lives (provided that they make payments on their policies). Here are four common cash value insurance policies.

  • Whole life insurance is a type of insurance policy that allows the account’s cash value to grow at a fixed rate until the policy matures, which the cash value will then match the death benefit. Whole life insurance cash values are guaranteed.
  • ​With universal life insurance, the cash value is not guaranteed. Instead, the cash value grows at a variable rate that fluctuates with the market and the insurance company’s performance.
  • ​For indexed universal life insurance, the cash value is tied to the performance of an index, such as the S&P 500 or a similar index.
  • Variable life insurance grows its cash value by investing in stocks, bonds, or mutual funds. This type of cash value can grow faster but it carries more risks, too.

Term life insurance policies, in contrast, do not have a cash surrender value. It is a far less expensive option than cash value life insurance and protects insureds for a set period of time, such as 10 years.

Because cash value insurance is considered a relatively poor investment, most financial advisors recommend buying the comparatively cheaper term life insurance to protect your family. The money that you save on the premiums can be invested in an investment vehicle with better returns.

Getting Funds From a Life Insurance Policy

If you choose to take cash value out of your policy, it is important to make sure that your policy does not lapse. Doing so can cause you to lose your death benefit, so in the event of your death, your beneficiaries will not receive any funds.

As discussed below, there are a number of options for getting money from your cash value life insurance policy, from taking out a loan on your life insurance policy, paying life insurance premiums, or selling your policy to surrendering your policy. Understanding the advantages and disadvantages of each option will ensure that you are making a smart choice about your policy.

Taking Out a Loan on Your Life Insurance Policy

If you need cash for expenses or a purchase, you can take out a loan from the insurance company using the cash value of your policy as collateral for the loan.

There are substantial benefits to taking out a life insurance policy loan. First, it doesn’t involve a credit check or have an underwriting requirement. You can also keep the loan outstanding for as long as necessary. However, if you die without paying back the loan, that amount will be deducted from the death benefit that would be paid to your beneficiaries.

To obtain a loan from your life insurance policy, you simply fill out a form. Just be sure to either pay interest on the loan annually or watch the size of the loan compared to your policy’s cash value. If the loan amount is higher than the cash value of your policy, it could lapse, leaving you without coverage—and you might also be taxed on the loan.

Paying Premiums With Your Cash Value

For those with variable and universal life insurance policies, paying premiums with the cash value of the policy is another option for using the cash value. As with life insurance loans, you will have to carefully monitor the size of the cash value account to be sure that it does not drop too low, or your coverage will lapse. However, if you are savvy, you can use the cash value to pay premiums while maintaining the cash value.

>> Read More: Should you pay life insurance premiums monthly or annually?

Generally, whole life insurance policies do not permit insureds to pay premiums using cash value unless it’s a paid-up policy. This can allow you to stop paying premiums, but it will deduct from the policy’s death benefit. It will also reduce the amount available for a loan.

Other Ways to Get Cash from Your Life Insurance Policy

There are other ways to get funds from your cash value life insurance policy. If you no longer want coverage under your life insurance policy, you might consider surrendering your life insurance policy entirely. Your insurer will then pay you the policy’s net cash value. That cash value could be far lower or nearly at your total accumulated cash value depending on how long you’ve had the policy.

Another option is to sell it in a life insurance cash settlement. For this option, a company will purchase the policy for a greater amount than the policy’s cash value, but less than the death benefits.

This is usually a better option than surrendering your policy, as it will generally result in a larger amount of cash. However, you will have to pay income and capital gains taxes on the settlement and will often have to pay a fee to the broker.

You may also simply withdraw from your life insurance’s cash value in order to reduce your premium. This will allow you to maintain your life insurance coverage but reduce the death benefit. For variable and universal life insurance policies, a partial withdrawal reduces the death benefit by the same amount.

As long as you do not withdraw more than you have paid in premiums, you will not be taxed. And partial withdrawals for whole life insurance premiums could cut your death benefit by more than what you took out.

Finally, if you have a large cash value on your policy but don’t want to cash it out for yourself, you might be able to use it to increase the benefits for your loved ones. This can involve using dividends to purchasing additions on a whole life insurance policy, or simply adding more death benefits, if possible.

Although cash value life insurance is generally not seen by financial advisors as a great investment, it is one way to build wealth. Before investing in this type of policy, carefully review the advantages and disadvantages to be sure that it will work for you.