Cash value life insurance is a type of coverage that offers both a death benefit and living benefit. That living benefit is known as cash value.
A death benefit is the money a policy will pay the beneficiary should the insured person die. This is also known as face amount, and it can range from thousands to millions of dollars of protection.
If someone says, "I have a $500,000 policy out on my life," what they're saying is that if they die, the insurance company will pay their beneficiary $500,000.
Cash value is available with most permanent life insurance policies. It is a living benefit that provides the policy owner access to a cash value feature as a part of the contract.
Though this feature can serve several needs, there are also some myths about how it works.
Which type of life insurance policy generates immediate cash value?
The rate of cash value growth depends on the type of life insurance and interest accrual method. Premium amounts collected will also affect the cash balance.
How does cash value life insurance work?
The cash value component of permanent life insurance begins with a premium payment. The majority of premiums help cover the cost of the death benefit, while the extra goes into the cash value.
This cash part accrues interest and grows through investments. How the insurance company invests this money depends on the policy. It’s important to understand that cash value isn’t a feature of term life insurance.
Cash value is a benefit of these types of permanent insurance:
- Whole life insurance: This uses a fixed interest rate set by the insurance company and interest rate environment.
- Universal life insurance: The interest credited to the cash value is determined by the insurance company and can be based on other benchmark rates.
- Variable life insurance: The cash value’s growth depends on the performance of the sub-accounts held in the policy.
How to use the cash value
There are four main ways to gain access to the cash value in your policy.
1. Surrendering your policy
This is the most common method of accessing the cash value. It's also the reason it's called a living benefit. The idea is if you no longer need the life insurance coverage, you can, in essence, cash out.
When surrendering, you could incur taxes and surrender fees. The benefit of the surrender option is that you can get some, all, or more than you paid into the policy.
2. Withdrawing cash
Some types of universal life insurance have a cash withdrawal feature. There are two things to be aware of with a withdrawal. First, it could cause what's called a tax event. Second, a withdrawal will often reduce the death benefit.
3. Taking a loan
Borrowing from a life insurance policy is a viable choice when looking for a loan. As long as there's enough for what you're looking to borrow, you can take a loan against a percentage of the cash value balance.
Although the loan builds interest, the amount received is usually tax free. The balance of the loan will reduce the death benefit if the insured dies with a loan outstanding.
4. Premium payments
There are times when the cash value can not only buy more insurance but can cover premium due. Sometimes the cash is even enough to pay up the policy. This allows the policy to stay active for a lifetime, without the need for more payments.
Other cash value considerations
Cash value isn't as easy as pay your premium and watch it grow. There are some other pros and cons of cash value life insurance that are important to consider.
Taxes on cash value
There are tax benefits to having a cash value policy. The biggest is that it grows tax deferred. But when it comes time to access the cash, there as some tax events to watch out for.
A tax event occurs when the cash paid out is greater than the total premiums paid. If that’s the case, you may owe income tax on withdrawals that exceed the amount you’ve paid into the policy. Make sure to see a qualified tax professional to understand the impact on your individual situation.
Overfunding and single premium policies
If you wanted to maximize the tax-deferred nature of cash value, you may want to pay more than your scheduled premium to watch the cash grow.
Fortunately, this is possible with some types of cash value contracts. This is known as overfunding, and it's a method of overpaying your premium so that the excess goes into your cash value balance.
These can be incremental deposits or lump-sum, single premium payments. The benefit to a single premium is that a large amount gets deposited into the cash value. This equates to more potential compound interest earnings on a larger amount.
In theory, this will result in a greater cash value balance and a paid-up policy.
Modified endowment contracts, or MEC
A modified endowment contract is when the policy no longer qualifies for favorable tax treatment. In other words, you put too much money into the contract and it has exceeded federal tax limits.
The impact is that you can no longer withdraw or borrow money with the same tax benefits you enjoyed before. There are also potential penalties and changes to how the IRS views the policy.
Contract roles
When considering life insurance, it's important to decide who will own the policy. This is important with a cash value contract, because sometimes the owner and the insured are different people or entities.
Regardless, the owner is the person or entity who has the right to the cash value. It is not the insured, although often these are the same.
Is cash value life insurance a good option?
No matter the type of cash value policy, think of it for coverage first and to accumulate cash second.
Cash value life insurance should primarily be viewed as a tool for providing life insurance coverage, with cash accumulation being a secondary feature. It is not a replacement for traditional methods of saving or wealth building. However, it may be a suitable choice for individuals with significant discretionary income or those who have already maximized other tax-advantaged savings options.