Are you considering a life insurance policy that offers more than just a death benefit? Cash value life insurance might be worth exploring. Unlike term life insurance, which provides coverage for a specific period, cash value policies combine a death benefit with a savings component. But how does it work, and is it the right choice for you?
According to a 2021 study by LIMRA, a research firm, around 35% of U.S. households own some form of cash value life insurance.
Understanding Cash Value Life Insurance
Cash value life insurance, also known as permanent life insurance, is a type of policy that provides lifelong coverage as long as you pay the premiums. The key feature that sets it apart is the cash value component, which acts as a tax-deferred savings account. A portion of your premium payments goes toward the death benefit, while the remainder is invested by the insurance company, allowing the cash value to grow over time.
How Cash Value Accumulates
The cash value of your policy accumulates in several ways:
- Premium Payments: A portion of your premium payments is allocated to the cash value account.
- Interest Earnings: The cash value earns interest based on the insurance company’s investment returns.
- Dividends: Some policies pay dividends, which can be reinvested into the cash value account.
The cash value grows tax-deferred, meaning you don’t pay taxes on the earnings until you withdraw the money.
Types of Cash Value Life Insurance
There are several types of cash value life insurance policies, each with its own features and investment strategies:
Whole Life Insurance
Whole life insurance is the most straightforward form of cash value life insurance. It offers a fixed premium and a guaranteed death benefit, as well as a guaranteed minimum cash value growth rate. The cash value grows at a relatively slow but steady pace.
Universal Life Insurance
Universal life insurance offers more flexibility than whole life. The premiums and death benefit can be adjusted over time, and the cash value growth is tied to the insurer’s current interest rates, which can fluctuate. This type of policy may offer higher potential cash value growth but with more risk.
Variable Life Insurance
Variable life insurance allows you to invest the cash value portion in various sub-accounts, such as stocks, bonds, and mutual funds. This type of policy offers the potential for higher cash value growth but also carries more investment risk.
Accessing the Cash Value
One of the key advantages of cash value life insurance is the ability to access the cash value during your lifetime. There are several ways to do this:
- Withdrawals: You can withdraw a portion of the cash value, but any amount withdrawn above the policy’s basis (the sum of premiums paid) will be subject to income tax.
- Loans: You can borrow against the cash value, typically at a low interest rate. The loan does not need to be repaid, but any outstanding loan balance will be deducted from the death benefit.
- Surrendering the Policy: You can surrender the policy and receive the full cash value, minus any surrender charges or outstanding loans. However, this will terminate the life insurance coverage.
Pros of Cash Value Life Insurance
Cash value life insurance offers several potential benefits:
- Lifelong Coverage: Unlike term life insurance, cash value policies provide coverage for your entire life as long as you continue paying the premiums.
- Tax-Deferred Growth: The cash value grows tax-deferred, allowing for potentially higher accumulation over time.
- Access to Cash Value: You can access the cash value through withdrawals, loans, or by surrendering the policy.
- Potential for Dividends: Some policies pay dividends, which can be reinvested to increase the cash value.
Cons of Cash Value Life Insurance
However, cash value life insurance also has some potential drawbacks:
- Higher Premiums: Cash value policies typically have higher premiums than term life insurance, especially in the early years.
- Lower Initial Death Benefit: Due to the cash value component, the initial death benefit may be lower than a comparable term life policy.
- Potential for Low Returns: The cash value growth may be lower than other investment options, especially for whole life policies.
- Surrender Charges: If you surrender the policy early, you may face substantial surrender charges, which can significantly reduce the cash value payout.
Is cash value life insurance a good investment?
Cash value life insurance is primarily a life insurance product, not an investment vehicle. While the cash value component can provide tax-deferred growth and a source of funds during your lifetime, it may not offer the same potential returns as other investment options, such as mutual funds or stocks. The cash value growth rates, especially for whole life policies, are generally modest and may not keep pace with inflation over the long term.
Can I borrow against the cash value without any consequences?
While you can borrow against the cash value of your policy, there are potential consequences to consider. Any outstanding loan balance will be deducted from the death benefit paid to your beneficiaries. Additionally, if the loan plus interest exceeds the cash value, your policy may lapse, and you could face a significant tax liability.
How are the dividends from cash value life insurance taxed?
Dividends from cash value life insurance policies are generally not taxable if they are reinvested into the policy to purchase additional paid-up insurance or increase the cash value. However, if you take the dividends as cash payments, they are considered taxable income and subject to ordinary income tax rates.
Can I convert a term life insurance policy to a cash value policy?
Most term life insurance policies do not have a conversion option to cash value life insurance. However, some insurers may offer the ability to convert a term policy to a permanent cash value policy, such as whole life or universal life, during a specific conversion period. This option typically involves additional underwriting and higher premiums.
What happens to the cash value when I die?
When you die, the cash value of your life insurance policy is typically paid out to the insurance company, along with any outstanding loans or interest. Your beneficiaries will receive the death benefit as stated in the policy, minus any outstanding loan balances.
Conclusion
Cash value life insurance can be a valuable tool for those seeking lifelong coverage and the potential to build tax-deferred savings. However, it’s important to carefully evaluate the pros and cons, as well as your individual financial goals and risk tolerance. While cash value policies offer access to funds during your lifetime and the potential for dividends, they also come with higher premiums, lower initial death benefits, and the risk of low returns or surrender charges.
Ultimately, the decision to purchase cash value life insurance should be based on a thorough understanding of how it works, the specific policy features, and whether it aligns with your long-term financial plan. Consulting with a qualified financial advisor can help you determine if cash value life insurance is the right choice for your needs.