Cash Value Life Insurance Explained

Cash value is a component of some types of life insurance. This is a feature that’s typically offered within permanent life insurance policies, such as whole life and universal life insurance.

You can use the cash value as an investment-like savings account and take money from it.

While buying cash value life insurance may seem like a smart choice, it’s not always the right one. Understanding what cash value life insurance is and how it works will help you determine if it’s the best fit for you.

What Is Cash Value Insurance?

Cash value life insurance encompasses multiple types of life insurance that contain a cash value account. This cash value component typically earns interest or other investment gains and grows tax-deferred.

You have several options if you want a cash value life insurance policy. Each policy type accrues cash value differently, but in all cases, you can get to your cash value through a loan, withdrawal or surrender of the policy.

How Cash Value Coverage Works

Cash value coverage can provide lifelong coverage. When the insured person dies, a death benefit is paid to beneficiaries, as long as the premiums have been paid.

When you make a premium payment for cash value life cover, it goes three places:

  • Into the policy’s cash value.
  • To the insurer’s cost providing the death benefit.
  • Toward life insurance company fees and charges.

That means only a portion of what you pay winds up in cash value. The part that goes into your cash value account grows based on a fixed amount and/or on investment gains.

If you build up enough money in your cash value account, you may be able to use your cash value to cover premium payments. If you’re struggling to make the payments, this option could provide some relief so that you can keep the life insurance in force. Talk with your insurance agent to find out what rules apply.

One important aspect of cash value  insurance is tax code 7702. This tax code sets the guidelines for how much money can be paid into the cash value component of the policy without losing its tax-deferred status. If the amount of money put toward cash value exceeds these limits, it may be subject to taxes.

Types of Cash Value Insurance

When it comes to cash value life insurance, there are several different types of policies to choose from. It’s essential to know the difference among them if you’re considering buying cash value life insurance.

  • Whole life insurance: Whole life insurance offers a fixed monthly premium, a fixed rate of growth for your cash value and a guaranteed death benefit amount.. Because of these guarantees, whole life insurance is typically more expensive than other life insurance options.
  • Guaranteed issue life insurance: This is a type of whole life insurance that doesn’t require a medical exam or health questions. You cannot be turned down. Guaranteed issue life insurance may include cash value, but since coverage amounts are generally small, the potential cash value is small. It usually has a graded death benefit where beneficiaries won’t receive the full payout if the insured person passes away within two or three years after buying the policy, unless the death was due to an accident.
  • Guaranteed universal life insurance: This type of universal life insurance has fixed premium and death benefit amounts, and usually minimal cash value accumulation.
  • Indexed universal life insurance: Indexed universal life insurance connects cash value growth to gains and losses in an index like the S&P 500. You can typically adjust premiums and death benefits within certain parameters.
  • Variable universal life insurance: With variable universal life insurance your cash value growth is tied to sub-accounts containing investments of your choice, usually bonds and mutual funds. But you could lose money in the cash value based on the performance of the investments you choose. You can generally adjust your premium and death benefits within set limits.

Pros and Cons of Cash Value Insurance

Whether cash value  insurance is right for you depends on why you want a policy.

Benefits of Cash Value Insurance

  • Your beneficiaries receive a death benefit. Cash value life insurance is a permanent life insurance policy, which means it can remain in effect until you die as long as you pay the premiums due.
  • Participating life insurance policies have dividends. Many whole life insurance policies are “participating,” meaning you can potentially get life insurance dividends if the policy is from a mutual insurance company. Dividends can be taken as cash, added to your cash value, used to pay premiums or used to buy “paid up additions” that increase your death benefit amount.
  • You can add riders for extra coverage. One of the most common life insurance riders is an accelerated death benefit, which is often automatically included at no extra charge. Similar riders—but with an extra charge—for chronic illness, critical illness and long-term care let you tap into your own death benefit if you develop certain medical conditions.
  • Cash value cover offers tax advantages. Your cash value accumulates on a tax-deferred basis. So as your cash value grows, the IRS doesn’t take a cut. Also, if you borrow money against the policy, you won’t have to pay taxes on the loan. When you pass away, your life insurance beneficiaries receive the death benefit tax-free, as with all life insurance payouts.

Drawbacks of Cash Value Insurance

  • Cash value cover costs more than term life insurance. If you don’t need insurance for the duration of your life, and you don’t care about building cash value, term life insurance will give you the most coverage bang for your buck.
  • Cash value can take time to build. Some policies take a long time to build up any significant cash value. You could wait many years before you have a substantial amount to access.
  • Cash value is not paid to beneficiaries in most cases. When you pass away, cash value typically reverts back to the life insurance company. Your beneficiaries receive the policy’s death benefit amount minus any loans and withdrawals from the cash value you made.
  • Your policy could lapse if you borrow too much. If you take loans or withdrawals from the policy, you also have to make sure you maintain a minimal cash value level or your policy could lapse.
  • Taxes may apply. If you withdraw cash value or take the surrender value and terminate the policy, you can be taxed on the portion of the money that came from interest or investment gains.

Ways to Utilize a Cash Value Policy

There are various ways to tap into the cash value component of your life cover policy while you’re alive.

  • Take out a loan. You can borrow against the cash value of a permanent life insurance policy and use the money for anything you want—an emergency, supplementing retirement income or anything else. Your loan amount accrues interest until it’s paid back in full. State law can dictate the maximum policy loan interest rate. For example, in California, insurance companies can’t charge more than 8% a year.
  • Withdraw money from cash value. When the amount you withdraw includes investment gains, often referred to as the part “above basis,” that portion is taxable as income. Making a withdrawal reduces your beneficiaries’ future life insurance payout.
  • Surrender the policy for cash. If you cancel life insurance, it’s known as surrendering your policy. When you do this, you get back the cash value minus any surrender charge. The insurance company also subtracts any unpaid premiums or outstanding loan balances.

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