The cash value in life insurance, whether it’s whole life, variable, or universal life, is one of the main reasons why premiums are higher in this type when compared to term life insurance.
See, in term life insurance, you only pay for the actual death benefit and nothing else.
Permanent life insurance, on the other hand, requires that you pay for both the death benefit and the savings component—also referred to as Cash Value.
Put simply, the cash value in life insurance is the savings portion taken from the premiums you pay for your insurance.
Whole life, universal life, and variable life insurance all employ cash value investing.
But is it really worth having cash value in life insurance?
What are the advantages and disadvantages of having one of these types of policies? Let’s take a deeper look.
Life insurance with an investment component
Not all forms of permanent or whole life insurance are the same. Aside from the details and terms of the policies themselves, they also differ on the types of investments they participate in.
The length of time you hold the insurance, the insurance company itself (and its performance), market performance, fees, and operating expenses, and a myriad of other factors all play a part in determining the gains and losses of your life insurance cash value.
And even though it’s more expensive, fans of whole life and other permanent types of life insurance see value in having the option to invest a portion of your premiums into a money-growing vehicle.
And, it can make sense, especially if you have maxed out all other popular ways of saving for your retirement (401k, IRA, etc.,).
Plus, there are certain scenarios wherein permanent life insurance coverage provides more value than term life insurance.
And while people coming from the “Buy term and invest the rest” crowd will say that whole life insurance is not a good investment, it’s not necessarily true and really comes down to your own comfort level.
For example, let’s say John bought term life insurance and invested the rest of his money say, in a bond fund that brought him an average of 3.5% returns over a 20-year period.
Dan, on the other hand, went with a universal life insurance policy which gave him an average return of 4.5% over the same 20-year duration.
From a pure investment standpoint, Dan’s gains trumped John’s in terms of how much their money grew. Dan also had the flexibility over those 20 years to borrow or withdraw from his cash value (at an interest rate better than most banks) in case he needed money for any reason.
Aside from losing in terms of average percentage of returns, John should also prepare to pay a much higher premium when he chooses to renew his coverage.
Dan wouldn’t have to make a similar adjustment since whole life usually has a level-term premium policy.
So who do you think had it better?
Of course, this is a fairly simplistic scenario but I know you get the point.
While term gives you the freedom and flexibility to invest the “rest” of your monies using your own investment strategies, you still have to make sure you invest it smart enough to have significant gains over the returns of the cash value in life insurance.
And, as with investing in general, nothing is guaranteed. Only until you actually see the results can you safely conclude that you made the best choice.
How does cash value grow in different types of life insurance?
Not all types of permanent life insurance follow the same techniques for investing the money in your cash value. Here are the different strategies that each employs:
Whole life insurance cash value
- The insurance company sets a formula on how they will calculate and meet their guaranteed growth rate. In short, the rate is fixed and determined by the company.
Universal Life insurance cash value
- Cash value growth will be dependent on the interest rate in the market and life insurance company performance.
Indexed Universal life insurance cash value
- Cash value growth will depend on the index that the insurer invests in or you choose (S&P 500, for example).
Variable Life insurance cash value
- Funds are invested in sub-accounts, which are basically whole life mutual funds. The growth of cash value will depend on the sub-accounts performance.
What about term life insurance cash value?
Since you’re only paying for the death benefit on a term life insurance policy, it doesn’t have any cash value.
Here’s what happens to the premiums you pay for whole life, universal and variable life insurance
Premiums are divided and shared
- One part goes into the death benefit
- Another part goes into the cash value
- And the final part goes into the insurance company’s operating costs and expenses
Here’s how cash value in life insurance builds up
The insurance company will invest the cash value portion of your premium payments into (generally) conservative-yield investments.
They will allocate a larger portion of the premiums to the cash value during the first few years of the policy and gradually decrease it throughout the duration of the policy.
It’s the same with how home mortgages work—your payments in the early years go towards paying the interest. As the years go by, most of your payments will then be allocated towards paying the principal.
This is mainly why most policyholders don’t see significant growth in their cash value in the first few years of the policy. Only after hitting a long-enough time frame will the cash value have the chance to start to show significant growth.
Cash value versus Surrender value: What’s the difference?
They are not the same. Surrender value (or surrender charge) is the difference between the policy value (the actual benefit value of your life insurance coverage) and the cash value of the insurance. Also, you can’t borrow against your policy account value, you can only access funds from your cash value.
Is life insurance cash value worth it?
Here are some of the main reasons why paying for the cash value in your whole/universal/variable life insurance makes sense:
Use it for paying your policies premiums
After several years into the policy (the longer the better), the cash value should have grown enough with significant earnings. When this happens, the policyholder has the option to use the cash value in paying for the premiums.
You can borrow against it
The interest rate you get is typically lower than what most banks usually provide. This serves as another emergency fund source should money become tight.
Acts as another alternative investment portfolio
If you’re looking for another way to invest your money outside of the usual 401k, IRA, mutual funds, etc., the cash value in your life insurance serves as a good option. Depending on the type of life insurance you have, you still have control over which types of investments and risk-level your funds will be invested in.
A great way to boost your retirement funds
Given enough time to accumulate earnings (20 years or longer), the gains you can get from your cash value can serve as a supplement to your retirement income.
Ways to access the cash value in your life insurance
There are several ways you can access the cash in your policy.
- Via a loan or withdrawal
Whole life policies usually offer the loan option to its policyholders. For universal life insurance, both loans and withdrawals are typically available. In general, loans do not require a reduction on your death benefit while a withdrawal likely will. Check with your insurance company to learn how distributions and loans will affect your death benefit and cash value.
- Full surrender on your policy
Not really advisable unless it’s a last resort as this will mean you’ll lose all coverage on your life insurance. When you file for a surrender on your policy, the insurance company will apply a surrender charge.
This surrender charge is an amount that will be deducted from your cash value before they hand it over to you. Surrender charges are usually the highest in the first few years of the policy and typically have less impact if you surrender on it later on.
- Dividends in the form of cash
Participating whole life insurance from a common insurer may allow you to take dividends as cash.
- Sell the policy
Should something happen to the beneficiaries during the course of the policy (e.g the spouse passes away or the children no longer require financial support), you have the option to sell your life insurance.
Cash value in life insurance Pros and Cons
So what’s the real deal on your policy’s cash value? Let’s take a look at the good and the bad.
- You can use it for paying your premiums. And anyone paying for whole life insurance will agree that this will come in really handy since premiums can be expensive.
- You can use it for taking a loan against your policy. Note that your loan can be taxed if you lapse on your policy before you pay off the loan in full. The amount that taxes will be based on is the difference between the total premiums and the loan amount.
- Universal life and variable life insurance may allow you to make a full or partial withdrawal of your cash value.
- The funds you have in your cash value grow free from tax. As long as you only take out up to the amount you’ve paid in premiums, you won’t incur any taxes on the amount in your cash value.
- Your cash value is only taxable when it’s greater than what you have paid into the policy.
For example, if you’ve paid $30,000 in premiums and accumulated
- It generally takes a long time (20 years and above) to post any significant returns on your money (depends on several other factors)
- You’ll need to pay a lot more in premiums versus term life insurance
- Not all types of permanent life insurance employ the same method of growing the cash value
- Your beneficiaries won’t get the earnings from the cash value, they will only receive the face value of your policy.
- If you take a loan against it, the insurer will still charge you interest
How to make the most out of your life insurance cash value
When the policyholder of a whole, universal, or variable life insurance dies, the company will take any remaining amount in the cash value while the death benefit goes to beneficiaries.
In order to make sure this doesn’t happen, here are some of the ways you can avoid throwing your cash value back to your insurers:
- Increase the death benefit
While not necessarily recommended often (since you’ll miss out on the potential gains), it’s good to know you have the option to “transfer” the amount you have in the cash value into the death benefit. This will allow you to boost the final amount that your beneficiaries will get.
- Use it for paying life insurance premiums
A popular option among permanent life insurance policyholders since it takes off a considerable amount of expense off their backs. As we all know, whole life can be expensive so having a way to reduce the premiums will help. Plus, it allows you to squeeze every drop from your life insurance while you’re still alive.
- Take a loan against it
If you’re experiencing financial hardship, you can borrow against your cash value to help keep things afloat. Just try to pay off the loan completely as any outstanding balance will get deducted from the death benefit.
- Make a partial withdrawal
Most universal and variable life insurance policies allow you to take a portion of your cash value for personal use.
- Retirement fund income
With enough growth, you can tap into the earnings of your cash value and use it to supplement your retirement nest egg. It can be a nice little source of income when you’re no longer working.
What are your thoughts about cash value in life insurance? Do you think it’s something that could be useful? Or would you rather stick to term life? Let us know in the comments below!
If you are looking for more information about life insurance, reach out to us directly to receive a free quote.
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