How the cash value of life insurance works

The bottom line:

Cash value is a component of permanent life insurance policies.

Part of the insurance premiums you pay go toward building cash value.

You can access the cash value to use while you are living, but do it wisely.

• What is cash value life insurance?
• What life insurance policies have cash value?
• How is cash surrender value calculated?
• What are common reasons to access the cash value of a life insurance policy?
• How does accessing cash value from a life insurance policy work?
• What are the options for accessing your life insurance’s cash value?
• How much can you borrow from your life insurance policy?
• How do dividends from life insurance work?
• What are the income tax advantages of cash value life insurance?
• When do cash contributions trigger a modified endowment contract?
• Can you build up cash value faster?
• Is cash value life insurance better than term insurance?

Cash value life insurance is a type of permanent life insurance. It combines two functions: a death benefit that provides your family with a payout when you die, and a savings or investment vehicle. Not every type of life insurance has a cash value component. But some examples of ones that do are whole life insurance, universal life and variable universal life.

Cash value life insurance generally costs more than term life insurance. You’re paying for longer-lasting coverage and cash contributions that you can remove from the policy while you’re still living.

High-income earners often use permanent life insurance when putting together a complex end-of-life financial strategy. Retirees who are no longer earning income may also find it useful. Adults with someone who will always be financially dependent on them, like a child with special needs, may benefit from permanent life insurance. If you're worried about the ability to get insurance later on, this type of coverage may be a worthwhile option.

Three common types of permanent life insurance policies that have cash value are whole, universal and variable universal. But there are many more. Each life insurance policy accumulates cash value in a different way.

Whole life insurance is one of the most common cash value life insurance policies. In exchange for premium payments, you’ll get a death benefit and cash value. The policy generally won’t expire unless you stop paying premiums or surrender the policy. Payment options may range from single premium to limited payments to lifetime payments. A baseline interest rate keeps your cash value accumulating at a rate set by your insurer. Dividends may be available but are not guaranteed.

Universal life insurance provides a death benefit¹ and cash value. Generally, the policy won’t expire unless you don’t provide enough funding for the contract to remain active. Compared to whole life insurance, universal policies offer more flexibility in premiums. You can speed up or slow down your payment amounts. You can also choose from a few options on when your premiums will be due. Expect to earn interest on the cash value that generally keeps up with current market rates.²

One thing to note about slowing down premium payments: You’ll want to be mindful if you decide to slow down contributions. When you reduce premium payments, you may also decrease the cash value of your life insurance. Or decrease the death benefit available to your beneficiaries. Reducing premium payments can make it take longer to meet your life insurance policy goals. Always talk with a financial advisor before altering planned contributions.

Variable universal life insurance is one of the most feature-rich permanent life insurance options. It provides a death benefit¹ and cash value. And it also comes with investment options. This is combined with the flexibility of payment timing and frequency that comes with universal life. Variable universal life policies have investment subaccounts where you can invest the cash value of your policy. So, if the market performs poorly, there’s a chance that a variable policy can lose all its value and terminate. There are also fees associated with portfolio management. Together, these things can or may impact how quickly your cash value accumulates.

Similar to universal life, you’ll want to be mindful if you decide to slow down contributions. When you reduce premium payments, you may also decrease the cash value of your life insurance. Or you may decrease the death benefit available to your beneficiaries. Reducing premium payments can make it take longer to meet your life insurance policy goals. Always talk with a financial advisor before altering planned contributions.

The cash surrender value of a life insurance policy is determined by the amount of premiums paid, the length of time the policy has been in force and the size of your death benefit. Your exact cash surrender value calculation will depend on the insurer you choose. In some cases, you can customize the balance between cash accumulation and death benefit as you open a policy.

Keep in mind that, when you pay an insurance premium, the money goes three places: the death benefit, the cash value and the insurer’s cost of doing business.

People generally remove money from the cash value of their life insurance policy when they need money that may be income tax-free. They do this through a cash value surrender or a loan. The cash value can help fund major expenses. Four common reasons to surrender part or all of a policy’s cash value are listed below.

Before you cash out your policy, there are a few things you should know (and that we’re legally required to tell you). So be sure to read on to the next section when you’re finished to learn what you need to know before removing funds.

When it’s time for the kids to head off to college, you may need cash reserves to help out. You can access the available cash value of a life insurance policy to pitch in toward education. Doing so will temporarily or permanently reduce your death benefit.

Supplemental income for retirement can come from the cash value of a life insurance policy. If you choose to withdraw money, you’ll pay taxes on anything above what you contributed in premiums. As always, removing funds will reduce your death benefit.

Maybe someone bought cash value life insurance for you while you were young. Now that you’re older and ready to buy a home, you may have cash value money in the policy available to put toward a down payment. Before you access the cash value, be sure to calculate how much life insurance you may want to retain. Some people choose to keep their death benefit active at the coverage level they need and access the remainder of the cash value.

Your car breaks down, or a medical bill disrupts a financial goal. The available cash value policy is yours, and you can access it as long as you understand the consequences of doing so.

When you access the cash value of your life insurance contract, you’ll reduce your death benefit. You also may have to pay fees or taxes in some cases. Above all, life insurance is for providing your loved ones with a death benefit when you die.

Usually, you have to wait at least a few years before accessing the cash value of your contract. Taking a loan or withdrawal once it’s available will decrease your death benefit. If you withdraw too much, your contract could also terminate. So, there are a couple of things to keep in mind before taking money out. We recommend always talking with your tax advisor and financial advisor to learn about those implications upfront.

There are multiple options for accessing your life insurance’s cash value, including withdrawals, loans and full surrenders. It’s worth repeating that you’ll probably have to wait at least a few years after opening a policy to access the cash value that may have become available. If you access your cash value sooner, your life insurance may lapse. The funding needed to keep a contract active may change after removing cash value.

Many policies allow you to take a tax-free withdrawal up to what’s known as your basis or cost basis. The basis is the total of all the premiums you have paid—minus any previous withdrawals and dividends received. You already paid income tax on your money, so you won’t be taxed again. However, your death benefit may be permanently reduced by the amount of your withdrawal.

Let’s use Robin as an example. Robin bought a whole life insurance policy when she was 32 years old. She’d just had her first child and was in a high tax bracket. She liked the idea of using a cash value policy to continue protecting her assets—she already had a lot of them. Every month, she paid her premium.

But today, Robin is 58 years old. Her home is now paid for and she is no longer financially responsible for her children. Her financial strategy has changed. So she wants to lower her death benefit. Her financial advisor helps her do this. Together, they withdraw money from Robin’s policy, which lowers the death benefit.

As a result, Robin has withdrawn part of her policy’s cash value to use elsewhere. At tax time, Robin will pay income tax on any cash accumulation greater than the sum of premiums she’s paid through the years.

Note that the withdrawal Robin made has now reduced the cash value of her life insurance. Restoring value to the previous amount may not be allowed within the terms of her policy. Because of this, it’s important that she fully considers future needs when deciding between withdrawals and loans.

This hypothetical example is for illustrative purposes. It may not be representative of actual results.

When you take a loan, you’re taking cash value from your contract and reducing your net death benefit. You’re expected to repay that loaned money with interest. Once it’s repaid, your death benefit and cash value will be restored. Loans are generally income tax-free.

Let’s say disaster strikes and you die while the cash value from your policy is still on loan. (Or, maybe you decide that you don’t want to pay it back.) Loans will reduce the amount paid to your beneficiary when you die.

This is when you end your contract early. You may incur a tax penalty if you take all the cash value available. You’ll be taxed on any money you receive that is greater than what you made in payments while your contract was active. You’ll have cash, but you won’t have life insurance anymore.

The amount you can borrow from a life insurance policy is determined by the type of policy you have and its current cash value. How much you’ve paid in premiums can also impact how much is available to borrow. The consequences of borrowing may also be tied to how much you’ve paid in.

Once a life insurance policy allows borrowing, you can often borrow tax-free up to what's known as the basis in the contract. The basis is the total of all the premiums you have paid—minus any previous withdrawals and dividends received. Anything borrowed beyond that amount will require an income tax payment. Think of this last piece as new income that you haven’t paid taxes on before.

If you withdraw all or nearly all of the money from your life insurance policy, it will likely terminate. It's important to monitor your contract and ensure your funding is sufficient if you want to keep the life insurance active.

Your cash value life insurance may give you the ability to earn dividends. But those dividends aren't guaranteed. The decision to pay dividends varies with insurers and is based on multiple factors. You may see dividends from your life insurance when your insurer’s actual financial results are better than its assumed results. Financial results are based on factors like investment performance, business expenses and financial predictions for the year.

When available, dividends may be paid out or applied to your account. Here are some of the ways dividends might arrive:

• You may receive a check.
• Your coverage amount may increase or the value within your life insurance may rise.
• Premium payment may be lowered.
• If you have a loan, the loan repayment amount may be reduced.

Cash value in life insurance has three main income tax advantages: usually income-tax-free death benefits, tax-deferred cash accumulation, and usually income tax-free withdrawals and surrenders. In some cases, adding a large lump sum to your life insurance policy can result in the IRS reclassifying it as a modified endowment contract. These contracts have different tax-time rules than standard life insurance. More on that in the next section.

Death benefits are generally received income tax-free. However, everyone's financial situation is different. So, you'll need to double check what's true in your case. Generally speaking, the income-tax-free nature of death benefits is a big plus of having life insurance.

Many types of cash value life insurance come with an interest rate, dividends or investment options. That allows you to grow money inside your policy if economic winds are in your favor. There’s always the opportunity to lose money, too. Interest rates, investment returns and dividends aren’t guaranteed. And investment returns are subject to market volatility. But let’s say you experience the best-case scenario and your cash value grows. That growth within a life insurance policy can be tax-deferred. You usually don’t have to pay taxes on your gains until you take a distribution.

If you no longer need your death benefit coverage, in full or in part, you may be able to access the cash value of your contract to cover other financial needs. Although withdrawals are usually income tax-free, there are special cases where withdrawals and surrenders can generate an income tax liability. For example, a significant taxable event can occur if a contract terminates with outstanding debt. Contact your tax advisor and financial advisor for details.

Adding large lump sums of money to your policy can trigger your life insurance to be reclassified as a modified endowment contract by the IRS. Different rules apply to your tax liability under this classification.³ Other contract changes can also trigger the modified endowment contract status. Consult a financial advisor or tax professional before making changes to your cash contributions.

You can build up cash value faster by increasing the size of your premium payments if your policy allows it. For policies that don’t allow it, there may be other options. One of those options is a paid-up additions rider. With this insurance rider, you have the option to increase your death benefit by paying extra into your life insurance. This insurance rider may cost you extra to attach to your policy.

Whether cash value life insurance or term insurance is better for you will depend on your financial goals and priorities. Life insurance isn't one-size-fits-all. There are a range of types and features to consider—many of which can be customized to suit your individual needs. You may want to start by evaluating a term policy against a permanent policy, and then decide what’s right for you. A financial advisor may also be helpful if you’re looking for someone to guide you through the options. They can help you make choices that reflect your personal values and priorities.

In a nutshell, term life insurance helps provide simple protection during a set period of time—such as paying a mortgage or putting your kids through school. Cash value life insurance (permanent life insurance) gives you protection throughout your life as long as you provide adequate funding and your contract retains its value.

Ready to learn more about your life insurance options? Connect with a financial advisor near you.