Understanding Cash Value Life Insurance
Cash value life insurance is a type of permanent life insurance that remains in effect throughout the holder’s lifetime and includes a cash value savings component. This allows the policyholder to utilize the cash value for various purposes, such as borrowing against it, making cash withdrawals, or using it to cover policy premiums.
Key Insights
- Permanent life insurance policies like whole life and universal life can build cash value over time.
- Cash value life insurance is pricier than term life insurance.
- Cash value policies do not expire after a specific period, unlike term life insurance.
- Policyholders can borrow against the cash value of their life insurance.
- Withdrawing cash from the policy will decrease the death benefit.
Investopedia / Xiaojie Liu
Functionality of Cash Value Life Insurance
Cash value insurance provides lifetime coverage for the policyholder. Typically, it entails higher premiums than term life insurance due to the cash value feature. A segment of each premium payment is assigned to insurance costs, while the remainder is placed into a cash value account.
This cash value earns interest and defers taxes on the accrued earnings. As premiums are paid and interest accrues, the cash value grows over time. With the accumulation of cash value, the insurance company’s risk diminishes because the accumulated funds offset part of the insurer’s responsibility.
Illustration of Cash Value Life Insurance
Let’s consider a policy with a $25,000 death benefit, no outstanding loans, prior cash withdrawals, and an accrued cash value of $5,000. Upon the policyholder’s demise, the insurer disburses the full $25,000 death benefit. The cash accumulated in the value becomes the insurer’s asset.
The real liability cost to the life insurance company is $20,000 ($25,000 – $5,000) due to the $5,000 cash value.
Note
Whole life, variable life, and universal life insurance fall under cash value insurance, while term insurance does not.
Utilizing the Cash Value of Life Insurance
The cash value component offers policyholders a source of funds that can be accessed for various needs.
Withdrawals
Most policies permit partial surrenders or withdrawals, which reduce the death benefit. Withdrawal limitations vary across policies, such as frequency or capped amounts for removal (e.g., up to $500).
If the withdrawal exceeds the premiums paid into the cash value, the excess is taxable as ordinary income.
Policy Loans
Policyholders can take out policy loans from the cash value, subject to interest charges. The outstanding loan balance reduces the death benefit correspondingly if the policyholder passes away before the loan is fully repaid.
Premium Payments
Cash value can also be utilized to cover policy premiums. If the available amount is sufficient, policyholders can cease out-of-pocket premium payments and rely on the cash value account for coverage.
Why Choose Cash Value Life Insurance?
Policyholders of permanent life insurance can leverage the accumulated cash value, stemming from regular premium payments and additional interest and dividends credited to the policy.
Should You Consider Purchasing a Cash Value Life Insurance Policy?
Individuals aiming to build savings over several decades might consider cash value life insurance as a savings avenue, in conjunction with retirement plans like IRAs or 401(k)s. It’s important to note that cash values typically begin accumulating after two to five years, and accessing the funds may require waiting or incurring penalties.
Do Cash Value Policy Premiums Cost More?
Yes, cash value policy premiums are generally higher than standard life insurance premiums since a portion of the payment contributes to savings.
Effects of Withdrawing Cash from Life Insurance
Withdrawals from the cash value of a life insurance policy decrease the death benefit. Complete withdrawal terminates the policy.
Withdrawals from life insurance enjoy tax advantages, as the IRS considers them a return of premiums paid, allowing tax-free withdrawals up to the amount paid. Any dividends or interest gains would be taxable only after exhausting premium repayments.
Final Thoughts
Cash value life insurance enables policyholders to amass funds for future use. A portion of each premium is funneled into an interest-accruing savings account, allowing tax-free growth of the cash value over the policy’s duration. These funds can be accessed for various needs during the insured individual’s lifetime.