Have you been looking into insurance and considering a cash value policy? Cash value life insurance lasts your entire life and it also includes an investment component. We are going to discuss everything that you need to know about cash value life insurance to help you decide if it’s the right option for you.
What is cash value life insurance?
Cash value life insurance is a type of permanent life insurance. It has a cash value savings component. The cash value can be accessed by the policyholder while they are still alive and it can be used for a variety of purposes. There is also a death benefit for the beneficiary if the policyholder dies.
Universal life, variable life, and whole life insurance are all examples of cash value life insurance. Term insurance is not cash value insurance.
How does cash value work?
A portion of your premiums go to an investment account which is known as the cash value. This money grows with interest over time and the taxes are deferred on the accumulated earnings. The exact amount that goes into your cash value is determined by your individual policy. The cash value of the insurance will increase over time and it can only be used by you while you are alive.
The death benefit of the cash value insurance works the same as it does with term life insurance. As long as your insurance is still active, then your beneficiaries will get the death benefit as a tax-free lump sum. The cash value is separate from the death benefit, therefore your beneficiaries will not receive the cash value when you pass away. Any cash value that is left in your insurance after you pass away goes to the insurance company.
Each time you make a premium payment the cash will be split between 3 categories:
- Cost of insurance: this will fund the policy’s death benefit
- Fees: the insurance company’s operating costs and fees
- Cash value: your account within the policy which will accumulate value
How does cash value grow?
The cash value grows tax-deferred with interest. It is subject to a low interest rate and significant growth can take decades. However, over those decades, you may be able to double your dollar, which grows both the death benefit and the cash value.
Advantages of cash value insurance
- You can borrow against the cash value. You can take out loans for any reason but you will need to repay them, with interest, to maintain the death benefit.
- You can use it to pay for premiums once the cash value is high enough. This may allow you to eventually stop paying monthly premiums and retain your life insurance coverage.
- It is permanent insurance. For the majority of policies you will be guaranteed coverage until you die. There are some policies where you are only covered up until age 99 so it’s important to check the fine print.
- Part of the money that you pay in premiums contributes to your cash value account and forms the cash basis.
- The cash value of your life insurance grows tax-free. When you withdraw that money you won’t pay any taxes as long as you only withdraw up to the amount you’ve paid in premiums.
- You are insured even if your health changes. You are still going to pay the same premium that you always have even if your health deteriorates.
Disadvantages of cash value insurance
- More expensive than other insurances. The fees and monthly premiums are generally a lot higher than other types of insurance.
- Any withdrawals will reduce the death benefit.
- When you die, your beneficiary will get the face value of your policy but they will not receive any of the earnings. The earnings are only accessible by you while you are alive.
- There is a low rate of return. While the cash value does accumulate in value over time, the rate is very slow compared to other investment options.
What are the differences between cash value life insurance and term life insurance?
- Term life insurance has no cash surrender value. If you decide to give up your insurance then you won’t get anything in return.
- Cash value insurance is usually more expensive than term life insurance.
- Cash value policies also don’t expire after a certain number of years.
- You can borrow against your cash value insurance but not term life insurance.
- With term life insurance, if your health declines and you need to buy another term, then you will most probably have to pay a higher premium. If you have cash value life insurance then your premium will stay the same regardless of if your health declines or not.
Is cash value life insurance or term life insurance better?
One is not necessarily better than the other. If you are trying to decide if cash value life insurance or term life insurance is better for you then it’s important to think about your financial goals and priorities. Term life insurance is a simple protection during a set period of time such as when raising a child or paying a mortgage. Cash value life insurance gives you permanent protection as long as you keep paying your premiums. Talk to your financial advisor about which option may be the best fit for you.
What is 7702 life insurance?
Cash value life insurance is sometimes referred to as 7702 life insurance. 7702 is a section of the Internal Revenue Code. It was created to limit what could be considered as a life insurance policy and to make sure other investments weren’t reaping the same tax benefits.
How is cash surrender value calculated?
The cash surrender value of a life insurance policy is determined by the number of premiums paid, the length of time the policy has been in force and the size of your death benefit. The exact value will depend on who your insurer company is. There are some instances where you can customize the balance of cash accumulation and the death benefit.
What are some common reasons to use the cash value portion?
Some common reasons that people may use the cash value portion of their insurance include college, living in retirement, a house payment and using the money as an emergency fund.
Is life insurance with a cash value worth it?
Purchasing life insurance with cash value will depend on how much risk you want to take and how much flexibility you want to have. If you are thinking about purchasing cash value life insurance, it would be worth speaking to a fee-only financial advisor to find out if it’s right for you.
Can I withdraw my cash value from life insurance?
Yes, you can withdraw the cash value from your life insurance. Usually you have to wait a couple of years after purchasing the cash value life insurance to withdraw the cash value portion.
Most policies will allow you to make a tax-free withdrawal up to your cost basis. The cost basis is the total of all the premiums you have paid, minus any previous withdrawals and dividends received. When you access the cash then you will decrease the death benefit. We recommend talking to your financial advisor before withdrawing the cash value from your life insurance.
What happens to cash value at death?
When the policyholder dies, the insurance company pays out the death benefit to the beneficiaries, but they keep the cash value portion. The beneficiaries will not receive the cash value.
How long does it take to build cash value on life insurance?
The time it takes to build cash value on your life insurance will depend on your premium payments. The higher your premium payments then the higher your cash value will be.
What happens if I cash out my whole life insurance?
Cashing out your whole life insurance means that you will be ending your contract early. You will be taxed on the money that you receive that is greater than what you made in payments.
How much can I borrow from my cash value life insurance?
The amount of money that you can borrow from your life insurance depends on what policy you have and the current cash value. You can usually borrow tax-free up to 90% of its cash value. If you borrow any money beyond the cash basis then you will need to pay income tax.
Is cash value the same as the death benefit?
No, the cash value is not the same as the death benefit. When the policyholder dies, the beneficiaries will receive the death benefit but they will not receive the cash value.
Is cash value life insurance right for me?
Cash value life insurance is generally suited for those with complex financial needs such as high-income earners who have already maxed out their other retirement savings accounts and high-net-worth individuals. It’s important to talk to your financial advisor to decide if cash value life insurance is right for you. If you are interested in having a comprehensive financial plan, schedule a free discovery call with one of our fee-only financial advisors today.
Alvin Carlos, CFP®, CFA is an investment advisor and fee-only financial planner, in Washington, D.C that works with clients across the country. He has a Master’s degree in International Relations from SAIS-Johns Hopkins. Alvin is a partner of District Capital, a financial planning firm designed to help professionals in their 30s and 40s achieve their financial goals through smart investing, reducing taxes, retirement planning, and maximizing their money. Schedule a free discovery call to learn how we can help elevate your finances.