What Is Cash Value in Life Insurance? Explanation With Example
Cash value life insurance is a type of permanent life insurance that includes a cash value savings component that lasts the holder's entire life. The policyholder can use the cash value for a variety of purposes, including obtaining loans or cash or paying policy premiums.
How Cash Value Life Insurance Works
Because it covers the policyholder's entire life, cash value insurance is permanent life insurance. Because of the cash value component, cash value life insurance has traditionally had higher premiums than term life insurance. Most cash value life insurance policies require a fixed-level premium payment, with a portion of the premium going toward the cost of insurance and the rest going into a cash value account.
The cash value of life insurance earns a low rate of interest, with the accumulated earnings tax-free. As a result, the cash value of life insurance will rise over time. Because the accumulated cash value offsets a portion of the insurer's liability, the insurance company's risk decreases as the cash value of life insurance grows.
Example of Cash Value Life Insurance
Consider a policy with a death benefit of $25,000. The policy has a $5,000 accumulated cash value and no outstanding loans or prior cash withdrawals. When the policyholder dies, the insurance company pays the full death benefit of $25,000. Money deposited into the cash value is now the insurer's property. Because the cash value is $5,000, the insurance company's true liability cost is $20,000 ($25,000 - $5,000).
Advantages and Disadvantages of Cash Value Life Insurance
The cash value component provides policyholders with a living benefit from which they can withdraw funds. The net cash value of a life insurance policy is the amount left over after the insurance company deducts its fees and any expenses incurred during the policy's ownership. There are several ways to obtain funds. Partial surrenders or withdrawals are permitted for most policies, but they may reduce the death benefit.
Earnings are tax-deferred until they are withdrawn from the policy and distributed. Earnings are taxed at the policyholder's standard tax rate once distributed. Some policies permit unlimited withdrawals, while others limit the number of draws permitted during a term or calendar year. Some policies limit the amount that can be removed (for example, a minimum of $500).
Most cash value life insurance policies allow for cash value loans. The issuer will charge interest on the outstanding principal, just like any other loan. If the policyholder dies before the loan is fully repaid, the outstanding loan amount will be deducted from the death benefit dollar for dollar. Some insurers require loan interest repayment, and if it is not, the interest may be deducted from the remaining cash value.
Cash value can also be used to pay for insurance premiums. If there is enough money, a policyholder can stop paying premiums out of pocket and have the cash value account cover the cost.
Cash Value Life Insurance
Pros
- Can borrow against the cash value
- Can withdraw from the cash value in a tax-advantaged way
- Permanent life insurance
Cons
- More expensive out-of-pocket premiums
- Withdrawals reduce death benefit
- Unpaid policy loans and interest deducted from death benefit