What Is Cash Value Life Insurance & How Does It Work?

The main feature of life insurance is the death benefit — but it's not the only one. Some types of life insurance include extra benefits such as having a cash value. If you're considering cash value life insurance or just wondering how it works, this guide answers some of the most common questions.

Key Takeaways

• How It Works: The insurance company invests part of your premiums to increase the policy's cash value. This value can be borrowed against or withdrawn, but doing so may reduce your death benefit and could risk policy lapse.
• Benefits: Cash value life insurance provides a death benefit, potential cash value growth, borrowing options, and may offer tax benefits. The growth of cash value is typically tax-deferred.
• At Death: When you pass away, your beneficiaries receive the death benefit, not the cash value. If you borrowed from the policy, the death benefit will be reduced. The policy's cash value ends when the death benefit is paid out.

What Is Cash Value Life Insurance?

Some life insurance policies, such as whole life or universal life, have a cash value component. Part of your premium goes toward the cash value and has the potential to grow. You can also borrow from the cash value in your policy.¹

How Does Cash Value Life Insurance Work?

When you purchase a life insurance policy with cash value, you start building cash value as you pay the premiums. The life insurance company will invest your premiums, enabling it to provide the policy cash values. The way cash values grow depends on the type of policy purchased.

The policy owner can access the policy cash value through a loan or withdrawal, depending on the type of policy. If you take out a loan, the life insurance company will charge interest and reduce the death benefit until you pay the money back.

With some life insurance policies, you can use cash value to help pay for premiums. So one downside of taking a policy loan is that the cash value is no longer available to help pay for premiums. Before taking out cash value, confirm that you can keep up with your premiums to avoid a lapse in the policy. Finally, withdrawing from the cash value will reduce your future death benefit. There's a trade-off between accessing the cash value while the insured is alive versus saving the full death benefit for the beneficiaries.

Types of Life Insurance Policies With Cash Value

Only permanent life insurance policies build cash value. These policies can last your entire life as long as you keep up with the premiums. There are several types of life insurance policies with cash value:

Whole Life Insurance

Whole life insurance charges a set premium that doesn't change. For cash value, the company provides guaranteed values that slowly grow over time. It's a steady way to build cash over time.

Universal Life Insurance

With universal life insurance, you have some flexibility to adjust your premiums and/or death benefit to meet your changing needs. However, increases in coverage are subject to underwriting. There also must be enough cash value in the policy to cover monthly charges if a lower premium is paid than the amount selected at issue or if a premium payment is skipped. Additional premium payments may need to be made to keep the policy in force during lower interest rate environments. With universal life, cash value fluctuates according to market interest rates, so the amount you earn per year can go up and down.

Does Term Life Insurance Have Cash Value?

Term life insurance does not have cash value because it is temporary coverage. Your policy lasts a set amount of time, such as a five-year term or 30-year term. If you die during this period, the policy pays your beneficiaries the death benefit. If you outlive the term, your coverage expires. With term life, you typically pay less per month, but in exchange, you do not build cash value.

What Are the Benefits of Cash Value Life Insurance?

It May Grow Over Time

Each time you pay your premium, you might increase your cash value. Your cash value also has the potential to grow over time.

It Can Provide Loans for Temporary Needs

If you only need money for a short amount of time, such as to pay for a car repair or vacation, cash value gives you the option to request a loan and then pay the money back.¹

It Offers Potential Tax Advantages

Cash value typically grows tax-deferred. You may be able to defer taxes on gain in your policy because gains are not taxed until money is received.

Options for Using Cash Value

Some of the ways you could use cash value include:

Creating an Extra Emergency Fund

You can withdraw or borrow your cash value any time you need, so if you have an unexpected bill, you can use the cash value to help pay for it.¹

Paying Your Insurance Premium

Some policies allow you to use the cash value to help cover your life insurance premium. As long as you have cash value remaining, this may help you get a temporary break from paying your premiums. Your financial representative can provide more information on whether this may be right for you.

Withdrawing Money as Needed

Depending on your policy, you may be able to take withdrawals, which could be used to complement your other income, or you could save it for a major purchase such as a vacation.¹

Turning It Into Guaranteed Future Income

If generating more retirement income is your priority, you could use the cash value from your life insurance policy to buy an annuity. An annuity is a contract between you and an insurance company that allows you to contribute money in a tax-deferred account. In return, you can get regular payments as income.

Keeping It for the Future

If you don't need extra money for now, another option is to just do nothing with your cash value. It will continue to have the potential to grow, and will be there if you ever need the money in the future. Also, not taking any loans from your cash value will mean a larger death benefit.

Is the Cash Value of Life Insurance Taxable?

Tax rules for life insurance cash values are complex, but in general you will not owe income tax on the gains if you do not withdraw the cash value from your policy. IRS views life insurance cash value gains as taxable income, and as long as you don't withdraw the cash value gains in your policy, you will not owe income taxes.

When you take out cash value through a withdrawal, you can take out whatever amount you paid in premiums without paying taxes. You would only owe income tax once you take out cash value beyond what you paid for the insurance. For example, if you have paid $50,000 in premiums and you have $70,000 in cash value, you can withdraw up to $50,000 without paying taxes. If you need more than that, you would only owe tax on the amount withdrawn in excess of the $50,000.

However, when you take out cash value gains through a loan, you don't owe income tax as long as the policy is active. If you lapse or cancel a policy with an outstanding loan, the IRS then considers the loan to be a withdrawal and you would owe taxes on the gains.

On the other hand, if you keep the policy going for the rest of your life and then die, the death benefit will first be applied to the outstanding loan, and your beneficiaries would receive the difference. Keep in mind that the insurer may charge interest on your outstanding loan, and your beneficiaries would receive a reduced death benefit.

For more information on how cash value is taxed, consider speaking with a tax professional.

What Happens to the Cash Value of a Policy at Death?

When you die, your beneficiaries will receive the death benefit payment. With few exceptions, the cash value balance is not added to or directly included in the death benefit. The policy terminates, along with its cash value, upon payment of the death benefit. Taking out some of your cash value while alive, either through a loan or a withdrawal, may reduce the future death benefit.

As you weigh this information, it could be helpful to meet with a financial representative or a tax professional. They can answer your questions and help you decide how cash value life insurance may work for you.

¹Loans will accrue interest, and loans and withdrawals may generate an income tax liability, reduce the cash value and the death benefit, and may even cause the policy to lapse.