What is cash value life insurance and how does it work?

There are significant differences between term life insurance and the multiple types of permanent life products like whole life and universal life. The cash value in permanent policies is one of them. 

Whole life and universal life policies offer this benefit, but term life policies don’t. The trade-off for cash value life insurance is that you’ll pay a higher premium for coverage. 

Getting this type of life insurance makes sense for some consumers, but most people are better off purchasing term life insurance. Here’s what you need to know about cash value life insurance to determine if it’s right for you.

What is the cash value of life insurance?

Cash value is the savings component attached to permanent life insurance policies like whole life or universal life. It can only be used by the policyholder when they are alive and does not contribute to the death benefit. 

When you have cash value life insurance, your premiums pay into two parts of your policy: 

• The cash value 
• Towards the cost of insuring you 

Because you are paying for the cash value and the death benefit, premiums are higher than they would be for a term life insurance policy where you only pay for the death benefit. 

What types of life insurance offer cash value?

The main types of cash value life insurance are: 

• Whole life: In whole life insurance, the cash value amount accumulates at a minimum guaranteed rate, which is fixed. You can accelerate the rate of accumulating cash value by pouring the company dividends into the policy. 

• Universal life: Universal life insurance lets you use the cash value to pay for the policy premiums. The rate of cash value accumulation varies based on the interest rate decided by the insurance company. 

• Variable life: In variable life insurance, the cash value increases based on your investments in the mutual funds offered by your insurance company. Cash value growth is not guaranteed.

How does cash value life insurance work?

When you get a whole life or universal life policy, you pay a premium on either a monthly or annual basis. The way the premiums are set varies: 

• Whole life insurance policies have fixed premiums.
• Premiums for indexed universal life policies are more flexible. 

In an indexed universal life policy, you can pay a lower premium or skip premiums altogether if there’s enough cash value in the policy, says Sam Price, an independent agent with Assurance Financial Solutions.

Your insurance company will apply part of your premium payments toward the death benefit and invest the other portion in the market. The latter part is what builds up cash value. 

You get the most benefit from cash value while you’re alive. You can use it to supplement your retirement income, pay down debt or cover certain expenses. 

Here are three ways you can use cash value:

• Pay your premiums: Most insurers will only allow you to do this after you’ve owned the policy for at least a year, but in reality, it takes decades to build up enough cash value to pay your premiums. If you go with a universal life policy, you could end up depleting all the cash value built up in the policy.
• Take out a loan against your policy: You can take out a loan against your cash value, which you’ll have to pay back with interest. The downside to this approach is that if you don’t pay back the loan, the amount will be deducted from the death benefit your beneficiaries receive.
• Partially or fully withdraw money from your policy: You can withdraw money outright from cash value life insurance. Doing this in a whole life insurance policy could reduce the death benefit by more than the amount you withdraw. In a universal life policy, it may reduce the death benefit on a dollar-for-dollar basis. For example, if you have a $250,000 policy and withdraw $25,000, your beneficiaries will only receive a $225,000 death benefit from your policy.

Another important thing to remember about cash value life insurance is that you can’t surrender the policy in the initial years or you’ll lose value.

When is cash value life insurance a good idea?

Cash value life insurance can be a wise investment if you can afford the higher premiums.

However, you will usually see higher returns if buy term life insurance and invest the rest. This avenue means you’d take advantage of the lower premium term life insurance offers for a set period of coverage, typically up to 30 years. You’d then invest the cost savings in the stock market.

Pros and cons of cash value life insurance

While there are some benefits to a cash value life insurance policy, there are also a lot of drawbacks. 

If you’re weighing your life insurance options, consider whether you can afford the substantial premiums that come with a cash value life insurance policy. Cash value life insurance is usually only worth considering if you’ve maxed out other retirement accounts or want to invest with less risk than the stock market.

How long does it take for whole life insurance to build cash value? 

You should expect at least 10 years to build up enough funds to tap into whole life insurance cash value. Talk to your financial advisor about the expected amount of time for your policy. 

Remember that the government taxes those funds. Another option in many cash value policies is that you can take out a loan against your policy. However, you’ll have to pay interest.

Tapping into cash value is a potential revenue source in retirement. Just weigh the benefits and drawbacks and see if there’s another revenue source where you could get funds. 

Does term life insurance have a cash value?

Term life insurance does not have a cash value, which makes it a lot cheaper than permanent policies. The premium paid towards a term life insurance policy only pays for the death benefit. The simplicity and affordability of term life insurance policies makes it the best choice for most people. You should talk to an agent to discuss your life insurance needs so you get the right policy for your situation.

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