Life insurance needs are not one-size-fits-all. What works for one might not work for another. It is important you understand all the options available to you, as this will help you pick a plan that best meets your financial needs.
One of the more complicated types of life insurance is cash value life insurance. Such a policy serves two purposes. It provides a payout to your family when you die. Additionally, it accumulates wealth that you can use during your lifetime.
Continue reading to find out more about it.
What is Cash Value Life Insurance?
Many permanent life insurance policies include a savings component, called cash value. This account earns interest — at a fixed or variable rate — and grows on a tax-deferred basis.
Cash value of a life insurance policy is meant for you, the insured. This is in complete contrast to the death benefit, which is meant for your beneficiary.
You can take a loan against or withdraw money from the policy’s cash value and use the funds however you like. If you die and there is some cash value remaining in the policy, that will go back to the insurer. Your beneficiary will not receive the cash value upon your death, but only the policy amount.
The premium of a cash value life policy is used for three things:
- covering the cost of insuring your life
- paying policy fees and other charges
- fund the cash value account
Different types of permanent life policies accrue cash value differently, but each one lets you access it via a withdrawal, loan, or surrender.
- Whole Life Insurance - Your death benefit and monthly premiums will remain the same throughout. The policy will accumulate cash value at a minimum guaranteed rate. In the event of a participating policy (a policy with the potential to earn dividends), you can funnel earned dividends into the cash value account to accumulate wealth faster.
- Universal Life Insurance – Compared to whole life, a universal life policy offers more flexibility. Some universal life plans let you tweak the death benefit amount and monthly premiums within a certain range. Additionally, you can select the investment options that work best for you. With such universal life policies, the potential to earn money is higher, but so is the risk.
- Guaranteed Issue Life Insurance – Traditional life insurance policies generally require a medical exam, but that is not the case with a guaranteed issue. As long as you meet the age criterion, the insurer cannot turn down your request for coverage. However, the death benefit is small, usually not more than $50,000. Guaranteed issue life policies help people who otherwise will not get life insurance take care of their end-of-life expenses. However, some plans also include a cash value component. Since the policy amounts are small, the potential cash value is also small. Most guaranteed issue plans (if not all) include a waiting period, usually two years. If you die within this period, your beneficiary will receive the premiums paid but not the death benefit amount.
Life insurance policies that accumulate cash value are more expensive than those that do not, such as term life insurance. But how much more? Generally speaking, one can expect to pay six to 10 times more for a cash value life policy.
How Can You Access the Cash Value?
Your policy’s cash value is your money. You can tap into it as needed. However, the options available for accessing it depend on your policy type and the provider.
Use the cash value to pay the premiums
Certain universal life policies allow you to pay monthly premiums with the policy’s cash value. All the same, using this strategy while there is not much cash value or the rate of interest is low might not be a great idea. If the cash value drops too far, you risk losing coverage.
This strategy works best when you have already built-up sufficient cash value. You can maintain your policy for a long time at little or no extra cost to you.
For instance, let’s say you have a cash value of $10,000, while the annual premium for your policy is $5,000. If the cash value grows at a rate of 2.5% per year — which is a reasonable estimate — you can use the interest to pay half of your premiums.
Whole life policies, by contrast, usually do not let you use the cash value to pay premiums. To be able to do that, you will need to convert it into a paid-up policy. This option is not available with all insurers and comes into play only if your cash value is sufficiently large.
Borrow a loan against it
A policy loan is another way to tap the cash value. You can use the loan amount any way you like. Your insurer will not run a credit check for approval, nor are there any underwriting requirements. Since you are borrowing your own money, you can choose not to repay the loan. However, the amount you borrow, plus interest, will be deducted from the payout your family receives when you die.
These loans generally come with low annual interest rates. Whatever interest amount you do not pay gets automatically added to the loan balance. For this reason, you need to closely monitor the outstanding loan amount. If it exceeds your policy’s cash value, you will lose coverage.
Sell your life insurance policy
Selling your life insurance policy to a third party — usually a company — is called a life settlement. You may find this option attractive if you no longer want to pay premiums and your dependents have become financially secure.
In a life settlement, a third party buys your policy for an amount greater than its cash value but less than the death benefit. The new policyholder takes over the responsibility of paying the premiums and receives the death benefit upon your death.
Surrender the policy for its net cash value
A life settlement is more profitable than surrendering the policy. But there is no guarantee that you will find a buyer. If you cannot find one and want to cash out the policy, consider surrendering it.
Surrendering a life policy is the same as canceling it. The insurer will deduct the surrender charges and other fees from your cash value and pay the remaining amount. That is, you will receive the net cash value (actual cash value – surrender charges and other fees). And your coverage will cease to exist.
As you may guess, the net cash value is always lower than the actual cash value. However, the longer you hold on to your policy, the lesser the difference between the two. If you have had the policy for 12-15 years, you are likely to receive an amount that is close or equivalent to the actual cash value.
Make a partial withdrawal
If you are low on funds or want to make a large purchase, a partial withdrawal may be a good option. You can also consider this option if you need less protection than before. For example, your children are now financially independent, and you need coverage only for your spouse or partner.
With universal policies, each withdrawal reduces the death benefit amount on a dollar-for-dollar basis. However, some whole life policies reduce the payout by an amount greater than what is withdrawn. So, before you make a withdrawal, first check how it will affect the death benefit.
Increase your death benefit
Depending on your policy and insurer, you may be able to use the cash value to buy more life insurance. This way you can ensure the cash value that you have built over the years does not go into your provider’s pocket upon your death.
Advantages and Disadvantages
Benefits of cash value life insurance
Includes a forced savings vehicle
A cash value life insurance policy obliges the policyholder into saving money, which can be a good thing. We all know it is hard to save money, and many of us struggle to save enough. A compelled savings model can help break the cycle of spending too much and saving too little.
Cash value life insurance has a built-in savings component. Whether you like it or not, a part of your premium payments is funneled into this account. If you keep your policy active for long enough, eventually you will get more than what you had invested.
Serves as an additional investment vehicle
Life insurance is mainly a financial tool for securing the future of your loved ones. The payout can help them to live comfortably after you are gone. However, cash value life insurance serves an additional purpose. It also acts as an investment vehicle.
If you are a high-net-worth individual and have exhausted traditional investment vehicles, a cash value life insurance policy can help you create a financial safety net for your family and grow your wealth on a tax-deferred basis.
You can use the cash value in different ways
Cash value may be used to buy additional coverage or pay premiums. You can also withdraw from or borrow against the cash value and use the money as you like. And if you no longer need coverage, you can surrender the policy for its net cash value.
Drawbacks of cash value life insurance
As useful as cash value life insurance is, it comes with its own set of disadvantages.
Lower return than traditional investment vehicles
A cash value life insurance policy gives you a lower return than most traditional investment vehicles (if not all). To make matters worse, these policies have much higher fees than other investment vehicles.
Cash value life insurance is many times more expensive than term life insurance. It is also considerably more expensive than permanent life policies without a savings component.
Is Cash Value Life Insurance Right for You?
Cash value life insurance could make sense for people who want life insurance coverage and an investment component rolled into one policy. There are different types of cash value life policies, the most common being whole life and universal life.
Whole life insurance is simpler to understand and maintain than universal life. Everything is guaranteed here — the death benefit amount, the monthly premiums, and the rate of return on cash value.
Universal life insurance, on the other hand, offers more flexibility. Some universal life policies let you adjust your premiums and the policy amount. You can also pick investment options that perfectly match your risk tolerance and long-term goals. These policies, however, carry greater risk than whole life insurance.
Cash value life insurance provides coverage for your entire lifetime and accumulates wealth. It can be a great option for certain people. For example, if you are someone who has already maxed out traditional investment vehicles, such a policy may suit you better than term life insurance. However, cash value life insurance is more complicated. It is always a good idea to consult an experienced life insurance broker, like Dundas Life, to understand all available options.