Cash Value in Life Insurance
- Contents
- What is cash value?
- How does cash value grow?
- How do I access my cash value?
- A word on taxes
What is cash value?
Cash value is an investment account built into your permanent life insurance policy (a.k.a. cash value life insurance). Why do people combine investment and insurance into a single financial product? There are three significant benefits to this hybrid:
- Tax exemption — Whereas interest on other investments counts as taxable income, interest grows tax-free in life insurance cash value.
- Instant liquid — A rarity among interest-bearing financial products, cash value life insurance allows instant access to cash without penalties.
- Versatility — Most of the reasons for life insurance have expired by the time a policyholder ceases employment. This frees the policyholder to cash in his policy/investment and use the proceeds to fund his retirement.
How does cash value grow?
Cash value increases through two mechanisms: your premium payments and interest.
Premium payments
In whole life insurance, a portion of each premium (stipulated in your contract) passes into your cash value. In universal life insurance, the entire premium passes into your cash value.
Interest
The interest rate that a particular cash value life insurance policy enjoys depends on what type of policy it is:
- Traditional whole life insurance — The interest rate is guaranteed and fixed.
- Universal life insurance — The interest rate is declared by the insurer and may change at any time.
- Indexed universal life insurance — Interest is tied to a particular market index, specified in the policy.
- Variable life insurance — The policyholder decides where the cash value is to be invested and receives interest on said investment(s).
How do I access my cash value?
Whole life insurance policies offer the following three methods of access:
Surrender
At any time, you may terminate your permanent life insurance policy and claim its cash value, less any surrender charges imposed by the insurer. Surrender charges settle any unresolved expenses which your policy may have imposed on the insurer. The cash value, less surrender charges, is known as the surrender value.
Policy loan
You can apply for a loan from your insurance provider, up to the amount of your policy's surrender value. The policy serves as collateral for the loan. Your loan (and applicable interest) are deducted from your cash value and death benefit dollar for dollar, so it is beneficial to repay.
Collateral assignment
This alternative to a policy loan will not reduce your cash value or death benefit. You may assign your policy as collateral for a loan from any lender. If you fail to repay the loan, your creditor gains ownership rights in the policy for the amount of the loan.
Universal life insurance offers the option of a cash withdrawal, in addition to the all of the previous methods of access:
Withdrawal
You may withdraw funds from your policy's cash value, never to be repaid. A withdrawal reduces your cash value, dollar for dollar.
A word on taxes
Unlike many investments, interest earned on cash value is not subject to income tax. However, if your cash value grows to exceed your cost basis in the life insurance policy, the excess will be taxed if and when the policy is surrendered. Withdrawals (which are considered "partial surrenders") receive the same treatment for tax purposes.
To completely avoid taxes, then, withdraw from your cash value up to the amount of your cost basis, then take out a tax-free policy loan for whatever remaining funds you require. Beware of policy lapse at this point, however, because if your policy lapses, outstanding loans count as a distribution and so are treated the same as a withdrawal (for taxation purposes).
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