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How Does Cash Value Life Insurance Work?

How Does Cash Value Life Insurance Work?

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Cash value life insurance policies provide lifelong coverage combined with an investment account. A portion of your premiums are directed to the investment account — the cash value — and this money grows with interest over time. If you decide to cash in your life insurance early and surrender your coverage to the insurer, you will receive the policy’s cash value (minus fees). You can also access the cash value as a policy loan, use the cash value to pay premiums or make a partial withdrawal.

What is cash value life insurance?

Cash value life insurance refers to any life insurance policies that not only have a death benefit but also accumulate value in a separate account within the policy. Each time you make a premium payment, the money is split among three different categories:

  • Cost of insurance: the amount required to fund the policy’s death benefit
  • Fees and overhead: the insurance company's operating costs and fees
  • Cash value: your account within the policy, which accumulates value

A life insurance policy’s cash value is separate from the death benefit, so your beneficiaries would not receive the cash value if you passed away. Any cash value that’s left in your life insurance policy when you die is kept by the insurer. A life insurance policy’s cash value is essentially the amount of money you would receive if you decided to give up the policy to the insurer, or surrender your coverage. The cash value behaves like an investment as it grows tax-deferred with interest, as determined by the type of policy, and can be used as collateral for a loan.

Even though the cash value’s growth is tax-deferred, it will still take several years of compound interest to grow meaningfully. Plus, for the first several years of coverage the majority of your premiums are eaten up by the cost of insurance and fees, so cash value accumulation is slow.

That's why we generally don’t recommend a cash value life insurance policy if you’re fairly advanced in years. The older you are, the more likely that the cost of your premiums will outweigh any eventual benefit you see. If you need a permanent life insurance policy to cover estate taxes or leave an inheritance, guaranteed universal life insurance provides lifelong coverage with little to no cash value component.

Types of cash value life insurance policies

Cash value life insurance policies are typically permanent, meaning you have coverage for the entirety of your life so long as premiums are paid. Some of the most common types of cash value life insurance policies are:

PolicyHow cash value grows
Whole Life InsuranceCash value builds at a fixed rate determined by the insurer. It’s designed to reach the size of the death benefit when the policy matures (typically, when you turn 100).
Universal Life InsuranceBased upon market interest rates and the performance of the insurer.
Indexed Universal Life InsuranceBased upon performance of an index, such as the S&P 500.
Variable Life InsuranceCash value can be invested in certain aggregated portfolios offered by the insurer which are similar to mutual funds.

Term life insurance policies have no cash surrender value. This means that if you decide to give up your coverage to the insurer, you won’t receive anything in return. On the other hand, it’s also the reason why term life insurance is several times less expensive than cash value life insurance.

The only reason you’d get money back from an insurer with a term life insurance policy is if you have a return of premium rider. This rider adds to the cost of your premiums but ensures that you’ll receive a portion or the sum of premiums paid if you live past the term of the policy.

Dividends and participating cash value life insurance policies

Mutual insurance companies don’t have shareholders and are, in essence, owned by their policyholders. Therefore, if the insurer makes more money than is needed to run the business, they pay some of it back to policyowners in the form of a dividend. If you have a participating cash value life insurance policy, it means you’re eligible to receive a dividend. Dividends are not guaranteed, but most of the top mutual insurance companies have consistently distributed them for decades.

Dividends are distributed according to the size of your cash value. For example, if Jane had $20,000 of cash value and John had $10,000 of cash value, Jane would receive a dividend twice the size of Jon’s. You can take dividends as cash, use them to pay premiums or use them to buy additional coverage.

What is 7702 life insurance?

Cash value life insurance policies are sometimes referred to as 7702 life insurance. This just means that they’re compliant with section 7702 of tax regulation. Life insurance policies have a variety of tax benefits, such as the death benefit paid to beneficiaries being free of income tax. Section 7702 was created to limit what could be considered as a life insurance policy and make sure other investments weren’t reaping the same tax benefits.

How to access the cash value in your life insurance policy

Premiums for cash value life insurance can be incredibly expensive, so it’s important to understand all the ways you can take money out of your life insurance policy. Whether you want to get rid of your coverage and cash out your life insurance or simply take out a loan, there’s a variety of ways to take advantage of your policy’s cash value.

Even if you no longer want coverage, make sure not to let your policy lapse at any point. When a policy lapses, you lose the death benefit as well as any cash value you could have been paid.

Pay your premiums with the cash value

Variable and universal life insurance policies are often favored because they allow you to use the policy’s cash value to pay premiums. This strategy will only work for a short period of time if you start while the cash value is too small or if interest rates are low. In addition, you have to carefully monitor the cash value to make sure it doesn’t drop too far, or you may lose your coverage. But if you have a fairly large cash value with consistent returns, you can keep coverage in place for years at little to no additional cost.

For example, say 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 annually to cut your premium payments in half while maintaining the full cash value.

Whole life insurance policies typically don’t let you pay premiums using the policy’s cash value except if you convert to a paid-up policy. Not all insurers offer this option but, with a paid-up life insurance policy, the cash value is large enough that you can stop paying premiums out of pocket. You use the cash value to pay premiums. The downside to paid-up whole life insurance policies is that each premium payment is deducted from the policy’s death benefit. In addition, 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 in which the cash value of your policy is used as collateral. It can be used for paying medical expenses, buying a car or anything else you might need cash for. Since the insurer holds the funds to cover the loan:

  • There are no underwriting requirements
  • You can keep the loan outstanding for as long as you want
  • There’s no credit check, and the loan doesn’t appear on your credit report

However, if you pass away while the loan is outstanding, the value of the loan will be deducted from the death benefit your beneficiaries receive.

Borrowing against your policy’s cash value is simple and typically comes with quite low annual interest rates. But you need to either pay interest out of pocket annually or carefully monitor the size of the loan as compared to the policy’s cash value.

If you don’t make interest payments, the interest amount is added to the outstanding loan balance. If the total size of your loan ever exceeds your policy’s cash value, the life insurance policy will lapse, canceling your coverage. In addition, you will likely have to pay income tax on the loan.

Sell your policy for a life insurance settlement

If you want to give up your coverage and cash out your life insurance policy, you should first try to sell it in a life insurance cash settlement. You might want to do this if your premiums are high and you no longer have dependents, or they’re all financially secure. In a life insurance cash settlement, a company buys your life insurance policy for an amount that’s greater than the cash value but less than the death benefit. Some companies even buy term life insurance policies for cash, but only if you’re quite old or sick, so likely to pass away during the policy term.

You’ll have to pay income and capital gains taxes on the settlement. Be aware that any brokers that help pair you up with a settlement company will typically take a cut. But the net effect is that you will usually get more money than you would by surrendering your policy.

Once the policy is sold, the life insurance settlement company takes over premium payments and becomes the policy beneficiary. The downside is, you won’t always find a buyer and the process of being evaluated by a life insurance settlement company can take several weeks.

Surrender your life insurance policy for its net cash value

If you can’t get a settlement and want to cash out your life insurance, you can surrender your policy to the insurer. Simply let your insurer know and they will pay you the life insurance policy’s net cash value.

The net cash value is the “actual” surrender value of the policy. You will typically find it listed separately in your life insurance statements. The net cash value will generally be lower than your total accumulated cash value for the first several years of coverage as it’s reduced by fees and surrender charges. However, if you’ve had your policy in place between 10 to 15 years, the net cash value is likely to be close or equal to the total accumulated cash value.

Make a partial withdrawal of the cash value

If you don’t want to get rid of your life insurance coverage entirely but have fewer financial obligations, you can also withdraw a portion of the cash value. This provides you cash while reducing the life insurance policy’s death benefit. For example, if your children have done well in their careers, you may be less concerned about passing on an inheritance but still want some coverage for your spouse.

How a partial withdrawal works can vary based upon the life insurance policy:

  • Variable and universal life insurance policies - A partial withdrawal is similar to receiving a portion of the death benefit early, as the payout to beneficiaries is reduced by the amount you withdraw. So long as you don’t withdraw more money than you’ve paid in premiums, there are no taxes on the partial withdrawal. If you withdraw more than you’ve paid, it will be taxed as income.
  • Whole life insurance policies - We typically don’t recommend a partial withdrawal if you have a whole life insurance policy, as 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 simply surrender the policy if it’s too large.

Increase your death benefit with paid-up additions

If you have a sizable cash value but don’t have a use for it, you may be able to increase the amount of money left to your beneficiaries. This option isn’t always available, so you’ll need to check with your insurer, but it’s a simple way to make sure your family doesn’t just lose the cash value you’ve built up over time.

Similarly, if you have a participating whole life insurance policy from a mutual insurer, you can use any dividends you receive to purchase paid-up additions. Buying paid-up additions is similar to buying a small single-premium life insurance policy as you increase the policy’s cash value and death benefit but don’t have ongoing payments.

Finally, there are no medical exams or underwriting requirements involved in buying paid-up additions, so you can increase your coverage even if your health has gotten worse.

Maxime Croll

Maxime is a Director at ValuePenguin focusing on the insurance industry. Previously she was the Director of Product Marketing at CoverWallet, a commercial insurance startup, and helped launch NerdWallet's personal insurance business. Maxime has contributed insurance insights and analysis to Forbes, USA Today, The Hill, and many other publications.

Editorial Note: The content of this article is based on the author’s opinions and recommendations alone. It has not been previewed, commissioned or otherwise endorsed by any of our network partners.