For most people, term life insurance is going to be the best choice. It is inexpensive and easy to understand, and it does what it is supposed to do, provide a death benefit payout to a beneficiary if the insured dies prematurely.
But term life is but one of the different types of life insurance available.
Cash value life insurance is similar to term life in that it offers a death benefit payout. However, unlike term life, cash value life insurance provides some additional benefits. Let’s take a closer look.
Table of Contents:
- How Does Cash Value Work?
- Cash Value Benefits and Drawbacks
- Does All Life Insurance Have Cash Value?
- Can I Cash Out My Life Insurance?
- How Long Does It Take To Get My Cash Value?
- What Happens When You Borrow Money From Life Insurance?
- How Soon Can I Borrow From My Policy?
- Do You Have To Pay Back Loans?
- How Much Can I Borrow?
- Can I Cash Out Before Death?
- What Happens To The Cash Value When I Die?
- Cash Value Vs Surrender Value: What is the Difference?
- Is Cash Value Taxable?
- Why is Cash Value Life Insurance Bad?
Every cash-value life insurance policy has two critical numbers.
The “face value” is the death benefit the insurer will pay to your beneficiary when you die.
And the “cash value” (or “surrender value) is the amount the insurer would pay to you right now if you elected to forego the death benefit and cash out the policy.
With each premium payment you make, the policy’s cash value increases.
Basically, your present, vested interest in the policy’s face value is going up with each payment.
It’s analogous to a mortgage.
If you buy a house worth $200,000, but you had to borrow $200,000 from the bank for the purchase, you won’t receive much if anything if you sell now.
But, with each mortgage payment you make, you acquire greater equity in the home—that is, the portion of the sale price you would personally receive if you sold the home increases. Cash value is like equity in a life insurance policy.
One of the nice things about cash value, though, is that it doesn’t just build up from premium payments—it also grows and compounds.
Whole life vs Universal life
The mechanism for determining policy growth is one of the chief differences between whole life and universal life.
Whole life policies grow at a fixed, guaranteed rate. When you purchase a whole life policy, you have a pretty good idea of what the cash value will be in five, ten, or twenty years.
Universal life policies can grow in a couple different ways.
A variable life policy grows according to the performance of investments you choose from among the multiple options the insurance company offers.
Or, indexed universal life insurance policies tie growth to performance of a specific equity index, like the NASDAQ. Fixed growth is usually available, too, so that with some universal life policies, you can assign part of cash value to a fixed account and the rest to an indexed account.
The bottom line is that, the longer you keep a policy in place, the greater the cash value will be.
And cash-value life insurance is a legitimate financial asset—not just a number.
You can withdraw some or all a policy’s cash value, borrow from or against it, convert it into an annuity, or sit tight and watch it grow.
If you keep a policy in place long enough, growth and dividends will eventually increase cash value (and the death benefit) above the policy’s original face value.
A big advantage of cash-value life insurance is its versatility. In one policy, you get life insurance that will pay out upon your death, but you also get the steadily growing cash value that increases your overall wealth and can be a valuable retirement-planning asset.
Cash-value policies like whole life and universal life are “permanent life insurance.” So, there’s no risk of a policy terminating or the insurer refusing to renew.
Once you have a policy in place, you have life insurance at locked-in rates for as long as you want or need it.
As a savings or investment vehicle, cash-value life insurance has almost no risk of loss.
Whole life is guaranteed to grow at defined interest rates.
Universal life allows for more variability, but you can get a policy that offers a no-loss or minimum return guaranty.
And cash-value life insurance is more easily liquidated than many similar assets. You can withdraw cash or take a policy loan with little delay.
Main Drawback: Price
The most-cited drawback of permanent policies is that they are more expensive than term coverage.
This is true, but it’s a “you get what you pay for” situation.
Most term life policies eventually expire without paying out, and they have no tangible value unless and until you die.
With whole life or universal life, you know you will eventually see a payout on the backend in one form or another.
The other common critique of whole life in particular is that returns are lower than with many investments.
Whole life insurance is designed as a long-term savings vehicle with no risk of loss. You won’t see incredible returns like you can sometimes get in the stock market, but you also know you’ll never lose money.
Universal life is designed to allow policyholders to partially participate in bull markets, but without much down-side risk.
No, not all life insurance types have cash value.
In general, permanent life insurance policies have cash value, but term life policies do not.
Types of permanent life insurance include whole life, universal life, and final expense insurance (which is a form of whole life).
Term life policies eventually expire, have no cash value, and usually don’t provide any benefits if the insured does not die during the term—though a few term policies have riders allowing for partial payouts in the event of long-term disability or comparable conditions.
“Convertible term life insurance” comes with the option of converting a policy to whole or universal life.
If the conversion is elected, the policy will have cash value going forward. But as long as a convertible term life policy remains unconverted, it has no cash value.
Yes, but only if you have a policy that accrues cash value, like whole life or universal life. A term life policy has no cash value and therefore can’t be cashed out.
When you cash out a universal of whole life policy, you are accepting the current cash value (or “surrender value”) in lieu of the future death benefit.
Basically, you get the cash now and don’t have to pay anymore premiums, and the insurance company is relieved of the obligation to pay the future death benefit.
When you start paying premiums on a permanent life insurance policy, the policy will start accruing cash value. However, it takes a little while for cash value to grow into something sizeable.
Permanent life insurance premiums are apportioned between underwriting costs (the amount needed for the death benefit) and cash value.
With whole life, early premiums are weighted more toward underwriting, and, as a policy matures, the percentage devoted to cash value gradually increases.
After a few years, compounding policy growth and dividends add up to the point where cash value exceeds the total premiums put into the policy.
A policy that stays in place over an extended duration (ten or twenty years) ends up showing considerable growth on the premium investment.
Universal life policies tend to place a greater emphasis on cash value growth and usually build more quickly.
And universal life’s flexible premium structure lets you increase the funding rate for cash value early on, which significantly speeds up the timeframe necessary for strong returns.
Life insurance policy loans are a unique feature of permanent life insurance because, if you take a loan, the repayment schedule is more or less at your discretion.
You can make regular payments over an extended period or pay it back in lump sum when you have the funds.
Once you fully repay the loan, the policy’s cash value and benefit amount are the same as if you had never taken the loan.
If you don’t repay a policy loan or only pay it back in part, the loan balance is deducted from the eventual death benefit.
Or, if you elect to cash out while a policy loan remains outstanding, the surrender value will be decreased by the amount still owed.
Policy loans do accrue interest, but the rates are usually substantially lower than rates a commercial lender would charge.
Many policies offer wash loans, where the interest accrued in the policy equals the amount of interest the company charges for the loan.
The reason the interest rate charged is typically nominal is because you’re receiving what amounts to an advance on money the insurer has to pay in the future, so there’s not much risk on the insurer’s side.
An attractive feature of policy loans is that they don’t qualify as taxable income.
If you surrender a policy or make a large withdrawal, the withdrawn amount that represents growth (the amount above the premiums paid in) is taxable income.
But policy loans aren’t taxed, which makes them a good way to help fund retirement without increasing current income tax liability.
Eligibility for policy loans varies from company to company and policy to policy.
Structurally, a policy’s cash value serves as collateral for the loan from the insurer, so there needs to be enough cash value built up to support the loan.
Insurers also have varying standards as to what percentage of cash value you can take as a loan.
So, for instance, you might be able to borrow eighty percent of cash value with one insurer and ninety from another.
The face value, premiums, and type of policy will all affect how soon it has enough cash value to support a policy loan.
In general, policies that have been in place for around ten years will almost always be eligible for a loan, and plenty of policies will be eligible much sooner.
It depends how you look at it. An outstanding policy loan won’t hurt your credit score, and a life insurance company isn’t going to sue you for an unpaid policy loan.
Generally, policy loans are fully collateralized by cash value, so the insurance company can just wait and deduct the balance from the eventual policy proceeds. And, in some cases, that might be exactly what you want to happen.
The downsides of not paying back a policy loan are that unpaid loans decrease the available death benefit and accrue interest.
The interest is usually low, but it’s interest nonetheless.
So, if you need the death benefit to be available in full when you die, you should be sure to repay a policy loan.
But, if you don’t mind the death benefit being reduced by the loan balance, then repayment is more or less optional.
The cash available from a policy loan depends on the permanent life insurance policy’s current cash value and on the specific insurance company’s standards.
Policy loan caps are frequently in the neighborhood of ninety percent of cash value.
So, if your policy has accrued $10,000 in cash value, you would be able to take a policy loan up to $9,000.
Yes, but only if you have a permanent life insurance policy that accrues cash value.
Term life policies cannot be cashed out. They either pay out the policy proceeds if the insured dies, or the policy expires without payment.
With each premium payment you make on a whole life or universal life policy, you increase the policy’s cash value, which is basically your currently vested right to the eventual death benefit.
During life, you have the option of surrendering the policy and receiving its cash value now instead of the death benefit in the future.
A policy that stays in place long enough is “mature,” which means the cash value has increased to the point where it equals or exceeds the original face value.
At that point, you can cash out and receive the entire policy proceeds.
When you die, a whole life or universal life policy’s cash value essentially merges with its death benefit.
While an insured remains living, a policy’s death benefit is contingent on the insured’s eventual death.
“Cash value” is the percentage of the death benefit to which the contingency no longer applies. That is, cash value is the part the policyholder can receive without the insured dying first.
When a policy is triggered by the insured’s death, cash value is no longer applicable because the contingency for payment of the entire policy proceeds has been met.
However, with some policies that have been in place long enough, cash value growth and dividends will have increased the policy’s value to the point where the death benefit is greater than the original face value of the policy.
A permanent life insurance policy’s “surrender value” is the amount of money you can receive today if you elect to cash out and forego the right to the future death benefit.
“Cash value” is essentially your “equity” in a policy’s future death benefit. It’s the amount you have a right to tap into without the policy having been triggered.
Practically, it is mostly a distinction without a difference, and the two terms are often used interchangeably.
However, because cash value can be partially withdrawn, collateralized, or (in some cases) applied toward premium payments—all without actually “surrendering” a policy—it’s sometimes helpful to distinguish between the two terms.
Cash value can be taxable, but only under certain conditions.
First, only the amount of cash value representing policy growth is taxable.
The “cost basis” of a cash-value life insurance policy is measured as the total premiums paid to date.
Any cash value up to that point is considered principal and is not taxable because premiums were paid using after-tax money.
Second, cash value is only taxable when it is actually received.
Even if a policy has been in place for twenty years and has accumulated cash value significantly beyond the total premiums paid, that growth is only taxable income to the extent you pull it out of the policy.
Under IRS rules, cash-value withdrawals are considered as coming first from premiums and then from growth (the accounting method is called “first in, first out,” or FIFO).
So, partial withdrawals are only taxable to the extent the withdrawn amount exceeds the policy’s cost basis.
And, finally, life insurance proceeds are not taxable income to the beneficiary. To the extent cash-value growth and dividends have increased a policy’s death benefit above the original face value, the proceeds will still be tax-free when paid to the beneficiary upon the insured’s death.
Through most of the Twentieth Century, buying cash-value life insurance (especially whole life) was considered a wise financial decision for most people.
During your working years, your family is protected by the death benefit.
Then, when you reach retirement age, you can either tap the cash value as an asset to fund retirement or keep the policy in place as an inheritance for your heirs.
More recently, celebrity consumer-finance pundits like Suze Orman and Dave Ramsey have recommended against whole life.
In a nutshell, they say you are better off if you “buy term and invest the difference.”
That is, they want you to purchase term coverage to meet your life insurance needs and use the money you save with the cheaper premiums to invest for retirement.
The idea is that, if you invest the money in the stock market, you’ll see better returns than what you would get from whole life.
This critique is not illegitimate, but it does rely on a few unstated assumptions.
First, it assumes that you will reach a point where you no longer need life insurance.
By definition, term coverage eventually ends, which is a big part of why it’s cheaper—the vast majority of term policies never pay out.
But many people need to be certain that life insurance proceeds will be available, and term doesn’t provide that certainty.
If you need to provide for the long-term care of a disabled loved one, apply the money toward funeral costs, or guarantee estate liquidity, you’ll need permanent life insurance.
Second, “buy term and invest the difference” assumes that you will, in fact, invest the difference and see growth equal to historic stock market returns.
However, there is a distinct possibility of choosing the wrong investments or that the market will crash or stagnate.
And, of course, if you use the money for other things or just forget to invest it, the strategy won’t pan out.
Whole life offers fixed, guaranteed returns and no risk of loss.
Universal life is designed to allow for more growth in strong markets, but without significant risk of loss. Neither product is intended as a high-risk/high-reward investment.
They are secure, stable, reliable assets that can provide a hedge against market volatility.
For some people, “buy term and invest the difference” is a good strategy. For others, cash-value life insurance is the smarter play.
We don’t expect you to be an expert in cash value life insurance after reading this article, but we hope we provided you with some good information to chew on.
The bottom line is, whether you are in the market for term life or cash value life insurance, we can help you find the best policy for you, based on your specific needs and goals.
We work with dozens of the top life insurance companies. Our goal is to align you with the company and policy that best meets your criteria.
So what are you waiting for? Give us a call today and experience the IBUSA difference.