Looking for life insurance can be an overwhelming task. With various policy types, riders, and difficult wording, it very well may be difficult to unravel what bodes well for your own financial circumstance.
One part of life insurance that regularly leaves individuals befuddled is the cash value. This is an element that is frequently offered in permanent life insurance policies. Cash-value life insurance policies give lifelong inclusion joined with an investment account. A part of your premiums is directed to the investment account — the cash value — and this cash develops with interest after some time. On the off chance that you choose to cash in your life insurance early and give up your inclusion to the insurer, you will get the policy’s cash value (minus charges). You can likewise get to the cash value as a policy credit, utilize the cash value to pay premiums, or make a [partial withdrawal.
While cash value life insurance may appear to be a wise decision, it is not always the right one. This is what you need to know.
Table of Contents
- 1 What is cash value life insurance?
- 2 Types of cash value life insurance
- 3 How does cash value life insurance work?
- 3.1 Take Out a Loan
- 3.2 Pay your premiums with the cash value
- 3.3 Put up cash value as collateral to borrow from your insurer
- 3.4 Sell your policy for a life insurance settlement
- 3.5 Surrender your life insurance policy for its net cash value
- 3.6 Make a partial withdrawal of the cash value
- 3.7 Increase your death benefit with paid-up additions
- 4 Why is cash value life insurance bad?
- 5 Can I withdraw cash value from life insurance?
- 6 Is life insurance with a cash value worth it?
- 7 Conclusion
What is cash value life insurance?
Cash value life insurance alludes to any life insurance policies that have a death benefit, and also accumulate value in a different account within the policy. Each time you make a premium payment, the cash is divided among three different classifications:
- Cost of insurance: the sum needed to support the policy’s death benefit
- Fees and overhead: the insurance organization’s operating expenses and charges
- Cash value: your account within the policy, which gathers value
A life insurance policy’s cash value is independent of the death benefit, so your beneficiaries would not get the cash value in the event that you died. Any cash value that is left in your life insurance policy when you pass away is kept by the insurer. A life insurance policy’s cash value is basically the measure of cash you would get in the event that you chose to give up the policy to the insurer, or surrender your coverage. The cash value acts like an investment as it grows tax-deferred with interest, as dictated by the sort of policy, and can be utilized as collateral for a loan.
Despite the fact that the cash value’s development is tax-deferred, it will in any case require quite a lot of years of compound interest to develop seriously. Furthermore, for the initial few years of coverage, most of your premiums are eaten up by the expense of insurance and fees, so cash value accumulation is slow.
That is the reason why a cash value life insurance policy is not usually suggested if you are fairly old. The older you are, the more probable it is that the expense of your premiums will exceed any inevitable benefit you see. In the event that you need a permanent life insurance policy to cover estate taxes or leave an inheritance, guaranteed universal life insurance gives lifelong coverage with practically no cash value component.
Consider a policy with a $25,000 death benefit. The policy has no outstanding loans or earlier cash withdrawals and an amassed cash value of $5,000. Upon the demise of the policyholder, the insurance organization pays the full death benefit of $25,000. Money gathered into the cash value is now the property of the insurer. Since the cash value is $5,000, the actual liability cost to the insurance organization is $20,000 ($25,000 – $5,000).
Types of cash value life insurance
Whole life insurance is likewise alluded to as “ordinary life” or “straight life.” As the name suggests, it gives you inclusion for your ‘whole’ lifetime. The premium relies upon your age at the time you purchase, and stays the same as you become older. The most reduced premiums go to the individuals who get it when they are young, since they will pay into it the longest. Additionally, your cash value develops based on a fixed interest rate set every year in your policy by the organization. Some whole life policies let you pay premiums for a more limited time frame, like 15 years or until you are at the age of 65. Premiums for these policies are higher in light of the fact that you make premium payments during a short period of time.
Universal life insurance is also alluded to as “flexible premium adjustable life insurance.” It includes a savings component (cash value) that develops on a tax-deferred premise. The insurer invests a part of your premiums, and the profit from the investment is credited to your policy tax-deferred. Universal life insurance offers a guaranteed minimum interest rate, which implies that the insurer ensures a specific minimum return on your cash. If the insurer does well with its investments, the interest rate return on the accumulated cash value increments. Numerous universal life policies offer a no-lapse guarantee. This implies that as long as you pay the minimum premium, the policy will remain in force until it grows and develops completely. Nonetheless, paying the minimum guaranteed premium is rarely adequate to develop huge cash values.
Here, the death benefit and cash values shift. The organization invests your cash values into separate investment accounts, like portfolios of stocks, bonds, and other investments. These separate accounts resemble mutual funds. Besides, the organization ought to provide you with data (also called a prospectus) that portrays each separate account. As the policy proprietor, you pick separate accounts to invest the cash value. The cash values and death benefit vary because of increases or decreases in the value of the separate accounts. You take the investment risk as the policyholder.
Guaranteed issue life
It is a type of whole life insurance that is only accessible in little coverage sums, for example, $20,000. Some guaranteed issue policies will incorporate a cash value, however since coverage sums are little, the potential cash value will also be little. You cannot be dismissed for guaranteed issue life insurance, but your beneficiaries will not get the full payout in the event that you die within a few years after purchasing the policy (rules change from organization to organization).
How does cash value life insurance work?
Cash value insurance is permanent life insurance, since it gives coverage for the policyholder’s life. Generally, cash value life insurance has higher premiums than term life insurance due to the cash value element. Most cash-value life insurance policies require a fixed-level premium payment, of which a portion is dispensed to the cost of insurance and the remaining is deposited into a cash-value account.
The cash value of life insurance procures a modest rate of interest, with taxes conceded on the gathered profit. Therefore, the cash value of life insurance will increase over time. As the life insurance cash value increases, the insurance organization’s risk diminishes, in light of the fact that the gathered cash value offsets part of the insurer’s liability.
You can withdraw money from the cash value or take a loan against it and utilize the cash for anything you need: for an emergency, to supplement retirement pay, to pay premiums, or for anything else you like.
You can likewise get your cash value if you choose to end the policy. On the off chance that you end the policy with the insurer, you will get the cash value sum minus any surrender charge. This activity closes the life insurance coverage. There is ordinarily a surrender charge in the event that you end the policy within the initial few years after getting it. The surrender charge is a way for the insurer to cover the expense of giving you the policy.
Take Out a Loan
One option is to acquire against the cash value of your permanent life insurance policy. Your loan sum will build interest until it is repaid in full. The interest on a policy loan might be fixed or a variable rate that is determined by the insurer based on the current market rates. State law regularly directs what the maximum policy loan interest rate can be. Washington’s state, for instance, says that the maximum fixed rate is 6% per year and a variable rate should be somewhere in the range of 4% and 8% every year.
On the off chance that you do not reimburse the loan sum, and you die, the remaining loan balance (including interest) will be deducted from the life insurance payout to your beneficiaries. A few policyholders decide to utilize their cash value in this way, and want their beneficiaries to get a decreased payout. Another advantage to a policy loan is that it does not show up on your credit report.
Pay your premiums with the cash value
Variable and universal life insurance policies are usually favored because they permit you to utilize the policy’s cash value to pay premiums. However, this method only works for a short amount of time if you begin while the cash value is too little or if interest rates are low. Moreover, you have to thoroughly monitor the cash value to ensure that it does not drop drastically, or you may lose your coverage. Nevertheless, if you have a fairly large cash value with consistent returns, you can keep your coverage intact for years at almost no additional cost.
For instance, let us suppose your annual premium is $5,000, and you have $100,000 in cash value. You would just need the policy’s cash value to return a net 2.5% interest yearly to reduce your premium payments by half while keeping the full cash value.
When it comes to whole life insurance policies, they typically do not let you pay premiums through the policy’s cash value, unless you shift to a paid-up policy. Not all insurers offer this option but, with a paid-up life insurance policy, the cash value is huge enough that you can stop paying premiums out of pocket. The cash value is used to pay premiums. One con to paid-up whole life insurance policies is that every premium payment is deducted from the policy’s death benefit. Along with that, less cash value is available for other purposes, such as a policy loan.
Put up cash value as collateral to borrow from your insurer
A life insurance policy loan is a loan from the insurer where your policy’s cash value is used as collateral. You can use it to pay for medical costs, buy a car, or to purchase anything else you might need money for. Since the insurer holds the funds to cover the loan:
- The loan can be kept outstanding for as long as you want
- There are no underwriting requirements
- There is no credit check, and the loan does not show up on your credit report
However, if you die while the loan is still remaining, the value of the loan will be deducted from the death benefit your beneficiaries receive. Borrowing against your policy’s cash value is easy and often comes with quite low yearly interest rates. Nevertheless, you need to either pay interest out of pocket yearly or thoroughly monitor the size of the loan as compared to the policy’s cash value.
If you do not make interest payments, the interest sum is added to the outstanding loan balance. In the event that the total size of your loan goes above your policy’s cash value, the life insurance policy will lapse, canceling your coverage. On top of that, you will likely have to pay income tax on the loan.
Sell your policy for a life insurance settlement
On the off chance that you need to surrender your inclusion and cash out your life insurance policy, you should initially attempt to sell it in a life insurance cash settlement. You should do this if your premiums are high, and you presently do not have any dependents, or if all your dependents are financially secure. In a life insurance cash settlement, an organization purchases your life insurance policy for a sum that is more noteworthy than the cash value, however less than the death benefit. A few organizations even purchase term life insurance policies for cash, but only if you are very old or sick, and likely to die during the policy term.
You will need to pay income and capital gains taxes on the settlement. Know that any brokers that assist with matching you up with a settlement organization will also take a cut. Yet, the net effect is that you will typically get more cash than you would by surrendering your policy.
When the policy is sold, the life insurance settlement organization assumes control over premium payments and turns into the policy beneficiary. The drawback is that you will not always find a buyer, and the process of being assessed by a life insurance settlement organization can take several weeks.
Surrender your life insurance policy for its net cash value
On the off chance that you cannot get a settlement and need to cash out your life insurance, you can surrender your policy to the insurer. Just let your insurer know, and they will pay you the life insurance policy’s net cash value.
The net cash value is the “real” surrender value of the policy. You will normally find it is recorded independently in your life insurance statements. The net cash value will generally be lower than your total collected cash value for the initial few years of inclusion, as it is decreased by expenses and surrender charges. In any case, if you have had your policy set up somewhere in the range of 10 and 15 years, the net cash value is probably going to be close or equal to the total gathered cash value.
Make a partial withdrawal of the cash value
If you do not want to get rid of your life insurance coverage completely, but you want to have fewer financial obligations, you can withdraw a part of the cash value. This gives you cash while lowering the life insurance policy’s death benefit. For instance, if your children have done well in their careers, you may be less concerned about giving an inheritance, but you might still want some coverage for your spouse.
Your life insurance policy can have a huge effect on how a partial withdrawal works:
- Variable and universal life insurance policies – A partial withdrawal is the same as receiving a portion of the death benefit early, as the payout to beneficiaries is decreased by the sum you withdraw. As long as you do not withdraw more money than you have paid in premiums, there will be no taxes on the partial withdrawal. On the other hand, if you withdraw more than what you have paid, it will be taxed as income.
- Whole life insurance policies – A partial withdrawal is usually not suggested if you have a whole life insurance policy. This is because the insurer will often reduce your death benefit by a greater amount than you withdraw. You might want to consider a life insurance settlement or just surrender the policy if it is too large.
Increase your death benefit with paid-up additions
In the event that you have a sizable cash value but do not need it, you might have the option to expand the amount of cash left to your beneficiaries. This choice is not always available to you, so you will have to check with your insurer. However, it is a clear and simple method to ensure that your family does not simply lose the cash value you have developed over time.
Additionally, on the off chance that you have a participating whole life insurance policy from a mutual insurer, you can utilize any profits you receive to buy paid-up additions. Purchasing paid-up additions is like purchasing a little single-premium life insurance policy, as you increment the policy’s cash value and death advantage, but do not have ongoing payments. At long last, there are no clinical tests or underwriting necessities engaged with purchasing paid-up additions, so you can increase your inclusion regardless of whether your health has deteriorated.
Why is cash value life insurance bad?
Cash-value life insurance has high expenses
Another warning associated with whole life policies is the way they are sold. Given the cash value segment, agents outline whole life policies as tax-free investment vehicles. In any case, when you do the math, it is clear that life insurance ought to just be bought for security against the death toll. Purchasing a term policy and investing the difference between it and a whole life policy in mutual assets (or another customary investment) would create a far greater return. Any cash you eliminate from a whole life policy likewise decreases your death benefit. Cash-value life insurance additionally has a larger number of expenses and charges than other kinds of investments, including:
- Administration fees for maintaining the policy, including accounting and record-keeping.
- Cost of insurance. It is the actual price of your coverage. It depends on your age, gender, health, and benefit amount.
- Mortality and expense risk charges. Upon issuance, the insurance organization assumes that the insured person will live to a certain age. This charge compensates the insurance organization in case the insured person does not live as long as the insurance organization thought they would.
- Sales charges that incorporate the selling agent’s commissions.
The cash value is slow to accumulate
While cash value may appear to be advantageous, your policy will not accumulate it for several years after you purchase it. From an investment viewpoint, this can make the general rate of return a lot lower than a conventional record. For instance, say you make an initial premium payment of $10,000 for a cash value insurance policy. This does not mean you now have $10,000 in cash value. That is on the grounds that most of the cash you contribute right off the bat is utilized to pay for the expense of the inclusion. Contingent upon the amount you contribute, you may actually have a negative cash value early on. Meanwhile, putting $10,000 in stocks, bonds or shared assets is worth that sum until it grows or falls in value.
Cash-value life insurance is less flexible
Conventional savings accounts likewise offer greater adaptability. A 401(k) or IRA empowers you to begin and stop contributions whenever you want. Notwithstanding, whatever you have contributed will in any case keep on acquiring interest. With life insurance, that advantage is off the table. To keep the policy intact, you should keep paying the essential premium. Else, it might pass, making you lose inclusion. It is also conceivable to pass your policy on the off chance that you pull out a lot of the cash value. If this occurs, you may have to pay charges on the overdrawn sum. 401(k)s and IRAs likewise permit you to deduct your contributions from your tax obligations. Life insurance does not.
Can I withdraw cash value from life insurance?
It’s likewise conceivable to take withdrawals from your policy. In the event that the sum you pull out incorporates speculation gains, frequently alluded to as the part “above premise,” that bit is available. Similarly, as with taking a policy loan, making a withdrawal will decrease the life insurance payout to your recipients later on.
You may be permitted to pull out cash from a life insurance policy with cash value on a tax-exempt premise. Notwithstanding, if the sum you take out surpasses the measure of cash you have developed as the cash value under your policy, you will be required to pay income taxes on that cash.
By and large, you can pull out cash from the policy on a tax-free premise, however, simply up to the sum you have effectively paid in premiums. Anything past the sum you have effectively paid in premiums typically is taxable. Pulling out some cash will keep your policy intact. Withdrawing all the cash will drop the policy.
While it may bode well in specific conditions to pull cash from the policy, it will eat into the advantage that is paid to your beneficiaries when you pass away. Additionally, you could face an unwanted tax bill. Circumstances where it may not be a bad idea to pull out cash from a policy include:
- Covering an aging parent’s health care expenses
- Making a down payment on a new home
- Paying for college tuition
Is life insurance with a cash value worth it?
Your decision to purchase a cash-value life insurance policy will rely upon how much risk you want to accept and how much adaptability you want to have. A whole life policy is the most direct permanent policy since everything is fixed and guaranteed — the yearly value you pay, the death benefit, and the profit from cash value. Universal life insurance allows you to vary premiums and the coverage sum. The various kinds of universal life offer varying levels of risk and potential for gains for the cash value.
Cash-value life insurance is more complex than term life. You will require a trusted life insurance specialist to walk you through the choices. It is also a smart idea to hear a second point of view from a fee-only financial advisor to see whether cash-value life insurance is ideal for you.
Term life insurance is adequate for most young families. Financial organizers do not suggest cash-value life insurance as an investment unless you have maxed our contributions to tax-advantaged retirement accounts, like IRAs and 401(k)s, have saved for emergencies or other pressing needs, and can commit to a policy for the long term. That being said, it is reasonable to approach these policies cautiously and ensure that you understand what you are purchasing.
Cash value is an alluring choice for some life insurance purchasers, yet should not be your first investment option. All things considered, first, maximize other savings options like IRAs and 401(k)s. In case you are a high-income worker, and you have maximized your retirement account contributions and need an extra account for tax-deferred savings, a cash value life insurance policy may be a solid match. In the event that you simply need life insurance for covering financial obligations with a known end, similar to a mortgage or a child’s college tuition cost, a term life insurance policy is a superior fit.