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Permanent life insurance allows you to accumulate cash value over the life of the policy. While these cash value policies are traditionally more expensive than term life insurance, they provide flexible savings options that can be used in a variety of ways before you pass on.
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What is cash value life insurance?
Cash value life insurance is a form of permanent life insurance that accumulates cash value over the life of the policy. Term life insurance doesn’t build cash value, but permanent, universal and whole life policies do.
Cash value acts as a form of savings for the insured, but can often only be utilized while the policyholder is still alive. A portion of premiums are paid into the cash value of the policy and can be used for a number of purposes, including to boost the death benefit, cover premiums or save a retirement nest egg.
How do cash value policies work?
Each time you pay your insurance premium, your payment is split between your death benefit and your policy’s cash value. The money you pay toward the cash value goes into an investment account. Over time, those dollars will grow tax-deferred.
Types of cash value policies
With these policies, a portion of your premiums are invested to give your policy a cash value. There are three types of life insurance policies that accumulate cash value:
- Whole life. The cash value of a whole life policy builds at a fixed rate of return.
- Universal life. The cash value is tied to a stock index, such as the S&P 500, and earns interest based on the current market rate. As such, the returns on your universal life policy may fluctuate over time.
- Variable life. When you apply for a variable life policy, you’ll be given a portfolio of stocks, bonds and mutual funds that match your risk tolerance. The cash value will then be invested into those accounts, which are managed by your insurer. Variable life offers the highest potential of return, but it’s risky – which is why it’s usually offered by prospectus only.
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What can I use the cash value of my policy for?
The cash value of your insurance policy is a flexible form of savings, which means there are a number of actionable options.
Take out a loan.
If you’ve built up enough cash value in your policy, you can take out a loan. The perks of borrowing against your policy’s accumulated cash value? There’s typically no credit check, no underwriting requirements and insurers often offer cash value loans at more competitive rates than traditional providers.
But borrowing against your policy’s cash value is a risky endeavor, as it could reduce your death benefit when you die. While you’re not obligated to pay back the loan, if you fail to pay back what you borrow, the amount of the loan plus interest will be deducted from the total death benefit of the policy after you pass.
Make a big purchase.
If you need cash for a big purchase, you can withdraw some or all of the accumulated cash value in your policy to cover a large expense.
Similar to taking out a loan against your policy, this option may also reduce the size of your death benefit. Your provider may reduce your death benefit on a dollar by dollar basis, or you may lose your death benefit altogether.
Talk to your provider about its policies on borrowing against accumulated cash value before you make a decision.
Save a retirement nest egg.
Your life insurance’s cash value could help supplement your retirement income. The longer you let your cash value grow, the greater your investment later in life. But you may need to surrender your policy to access your policy’s cash value.
When you surrender your policy, you forfeit your death benefit entirely and are no longer insured. Your insurer may also charge you a surrender fee. Since surrendered cash value is also subject to income tax, this will further reduce the amount you receive when surrendering your policy.
Once you’ve built up enough cash value in your policy, you may be able to use it to cover the cost of your premiums. This option is best exercised by those who have built a sizable cash value in their policy.
Using the cash value of your policy to cover premiums reduces the total cash value in the policy. Should your policy’s cash value drop too low, you could stand to lose your death benefit entirely, defeating the purpose of the policy altogether.
Increase the death benefit.
If you don’t have any plans for the cash value in your policy, you can opt to empty the accumulated cash value into a boosted death benefit, providing more money to your beneficiaries after you pass.
Whole life policies from mutual insurers may allow you to purchase paid-up additions to your policy. Using the dividends from your policy, you can add a rider to your existing policy that increases the amount of your death benefit.
Policies and protocols differ by provider, so ask your insurer how you can convert the cash value accumulated in your policy into a larger death benefit for your beneficiaries.
Risks involved with cash value life insurance
Interest rates have a direct impact on the life insurance industry, and especially on whole life insurance policies. Life insurance companies base their entire business model on interest and on the assumption that interest rates will grow over time.
Life insurance companies use the premiums they receive to invest in things such as bonds and mortgages to grow their portfolio and to pay out death benefits. When interest rates rise and fall, they have an impact on everything from new sales and dividends, to cash flow and future financial obligations to policyholders.
Generally, insurance companies are financially stronger in high interest economies. In a low interest environment, there are a few specific consequences affecting dividends, rate-of-return, and product pricing.
- Dividends. Cash flow is usually tighter with low interest rates, meaning companies won’t pay as much in dividends. Insurance companies need to make sure they have enough money to pay their policies.
- Rate-of-return. Longer term low interest rates will mean that your own policy is earning lower interest on its cash value. This can significantly lower the value of your policy and is something you may want to review every few years.
- Product pricing. Buying a new policy in a low interest environment could save you money, as insurance companies tend to lower their prices. However, lower prices also mean lower interest rates, which can mean low rate-of-return.
Is a cash value policy worth it?
It depends on a few things: a) your budget, b) your risk tolerance, and c) why you’re buying life insurance.
Cash value policies can be complicated and expensive. Some of them – like variable life – also require you to be hands-on with your policy.
- Whole life is the least risky option because it builds at a fixed rate. That means your cash value will earn a guaranteed rate of return – even if the market dips. It’s also predictable in that your premiums and death benefit will never change.
- Universal life offers more flexibility and the freedom to adjust your premiums and coverage amounts. You just have to be comfortable with the fact that your gains may ebb and flow with market conditions.
- Variable life is best for high net-worth individuals, or those who have money stashed in other investments or savings accounts. It has the highest potential for returns and losses.
If you’re using life insurance purely for investment purposes, you might be better off contributing to a 401(k) or IRA. And if you want your policy to function as an emergency savings account, keep in mind that it can take 10 to 15 years to build up the cash value you need to start borrowing against your policy.
Cash value life insurance helps you build your savings over the life of your policy. With accumulated cash value, you can borrow against your policy, build your retirement nest egg or take a larger death benefit. But the buildable savings of cash value life insurance isn’t without its drawbacks, namely: expensive policy premiums.
If you don’t plan to utilize the perks of a cash value policy while you’re alive, you may want to consider your life insurance options with other providers to get a policy that fits the needs of you and your family.
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