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One of the most "adult" things you can do is shop for life insurance, but there are so many types to choose from it can be hard to decide. Cash value life insurance is an option, although it may not be the best. Here, we'll tell you more about cash value insurance and help you decide whether it's right for you.
What is cash value life insurance?
There are two primary types of life insurance: term and permanent. As the name suggests, a "term" policy only lasts for a specified time. As long as the policyholder keeps up with the premiums, permanent life insurance is meant to be lifelong. Cash value life insurance is a type of permanent policy. In addition to the face value of the life insurance (the amount the policyholder is insured for), it builds cash value. A portion of each premium payment is put aside, and the cash that accrues earns interest, and may be available to withdraw or borrow against.
How cash value life insurance works
Cash value life insurance offers two features in a single policy:
- Death benefit. This is the amount paid out to a policyholder's beneficiaries after they die. It is sometimes referred to as "face value." The face value of life insurance is how much someone shops for once they've answered the question, "How much life insurance do you need?" For example, if a person with a young family is concerned about how their family would get by after their death, they may look for enough coverage to pay things like the remaining mortgage, their kids' education, and other everyday expenses. Adding up the expected cost gives a rough idea of how much a death benefit should be.
- Cash value. Not all permanent policies offer cash value, but those that do typically give the policyholder access to those funds while they're still alive. One benefit is that the cash value portion of a policy builds tax-deferred interest. The amount of interest depends on the type of policy.
Types of cash value life insurance
Each of these policy types may build cash in the life insurance policy:
Whole life insurance
Whole life is the most common type of permanent policy. In essence, it offers a death benefit along with a savings account. Each insurance company sets its own interest rate or dividend it pays on whole life insurance cash value.
Universal life insurance
Universal life insurance is a bit more flexible. As long as the policyholder passes a medical exam, they may be able to increase the death benefit even after they've held the policy for some time. In other words, the benefit isn't locked in. The cash value account portion of the policy usually earns interest around the same rate as a money market account. Once enough cash has accumulated, the policyholder can use some of those funds to pay premiums (or part of the premiums).
While using the life insurance net cash value to pay premiums sounds great, it is not without risk. Once the cash value is used up, the policy runs the risk of lapsing.
Variable universal life insurance
Another type of permanent life insurance is variable universal. In addition to a death benefit, this policy takes the money that accrues as cash and invests it in stocks, bonds, and money market mutual funds. If the market is up, the cash can grow rapidly. When the market drops, the policyholder runs the risk of losing both the cash and part of the death benefit. Some, but not all, companies guarantee that the death benefit will never drop below a specific amount.
Indexed universal life insurance
There is also a death benefit and savings component with an indexed universal life policy. The difference is that the cash value in the account earns interest based on how a specific stock market is doing. The policyholder has no say in which stock market is used, although they do know when they purchase an indexed universal life insurance policy which market the company plans to use. Most policies come with an interest rate guarantee, meaning the interest rate can't fall below that benchmark no matter what happens in the market.
Does term life have a cash value?
Term life does not build cash value. However, the cost of a permanent life policy is typically five to seven times more than the cost of a term life policy.
Pros and cons of cash value life insurance
As with everything, there are pros and cons with cash value life insurance.
Pros
- As long as the policyholder continues to make the premium payments, their life insurance policy can last their entire life
- Cash value can be used in several ways
- Cash value grows on a tax-deferred basis
- May be able to borrow from your life insurance policy
Cons
- Premiums for a cash value policy are more expensive than premiums for term insurance coverage
- Fees can be prohibitively high
- There are less expensive ways to invest on a tax-deferred basis
- Cash value policies tend to be complex
Who should buy cash value life insurance?
While term life insurance is less expensive and other types of investments provide a better return, there are some circumstances under which buying a cash value life insurance policy makes sense. Here's who may benefit:
- A person who does not trust themselves to save money.
- Someone who plans to leave life insurance as part of an inheritance.
- A person with a large estate who wants to leave enough in a permanent life policy to pay estate taxes. To put this in perspective, the estate tax exemption for 2022 is $12.06 million for an individual and $24.12 million for couples.
What makes cash value policies risky is how much more they cost than term life, the extremely high fees the policyholder usually pays, and the complexity of the policies. Before being talked into a cash value policy by an agent (who may well get a nice payday when a policy is purchased), it behooves a person to compare whole vs. term life insurance and to speak with a financial advisor about better ways to invest.
FAQs
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Term life costs less, leaving money to invest in ways that have historically earned more money than cash value life insurance.
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While cash value life insurance works for some people, its problems include high costs and fees and complex policies.
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The only type of life insurance that generates immediate cash value is a single premium paid-up policy.
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The insured does have a right to cash in a life insurance policy. What happens when they do depends on how long the policyholder has had the policy. If it isn't very old, they may have to pay surrender fees that lessen the amount of cash they receive. Earnings on the policy will be taxed.
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It's possible to borrow against life insurance, but the policyholder is charged interest even though they're borrowing against their own money. If they decide to cash the policy in to pay debt, they could face surrender fees, pay taxes on earnings, and lose the death benefit.
Our Insurance Expert
Dana George has a BA in Management and Organization Development from Spring Arbor University. For more than 25 years, she has written and reported on business and finance, and she's still passionate about her work. Dana and her husband recently moved to Champaign, Illinois, home of the Fighting Illini. And though she finds the color orange unflattering on most people, she thinks they'll enjoy Champaign tremendously.
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