Does Life Insurance Have Cash Value?

Understanding Cash Value

Life insurance policies offer a death benefit, but some also include cash value, a living benefit accessible by the policyholder. This cash value is distinct from the death benefit and depends on the policy type.

Cash value accumulates as a portion of premium payments. A part of each premium is allocated to this cash value, after covering insurance costs and administrative expenses. This creates a savings element within the policy.

Cash value growth varies based on policy structure. It can grow through a guaranteed interest rate, declared dividends, or investment performance. This growth contributes to the policy’s internal value, providing a financial resource separate from the death benefit.

Cash value builds equity within the policy, allowing policyholders to utilize these funds while the insured is still living. This feature distinguishes certain life insurance policies from others that solely provide a death benefit.

Life Insurance Types and Cash Value

Different types of life insurance policies either include or exclude a cash value component. Cash value presence largely depends on whether a policy is “term” or “permanent.”

Term life insurance provides coverage for a specific period, typically 10 to 30 years. These policies offer a death benefit if the insured passes away within the defined term. Term life insurance policies do not build cash value, as premiums cover the death benefit for that duration.

Permanent life insurance policies provide lifetime coverage, assuming premiums are paid. These policies consistently accumulate cash value. How this cash value grows and its characteristics differ among permanent life insurance types.

Whole life insurance is a type of permanent policy where cash value grows at a guaranteed rate. This predictability offers stability. Some policies may also pay dividends, enhancing cash value accumulation.

Dividends, though not guaranteed, can be used to purchase additional coverage, reduce premiums, or be taken as cash.

Universal life insurance policies offer more flexibility regarding premiums and death benefits. Cash value growth is tied to an interest rate, which can be fixed, indexed to an external benchmark, or variable based on market performance. This flexibility allows policyholders to adjust payments and potentially affect the rate of cash value growth.

Variable universal life insurance allows policyholders to direct cash value into various investment sub-accounts, similar to mutual funds. This offers potential for higher cash value growth but also carries increased risk, as value can fluctuate with market performance. The policyholder bears the investment risk.

Accessing Cash Value

Policyholders have several ways to access accumulated cash value within their permanent life insurance policies during their lifetime. These methods offer financial flexibility but also carry implications for the policy’s death benefit and future performance.

One common method is taking a policy loan. Policyholders can borrow against their accumulated cash value. These loans are not considered taxable income if the policy remains in force. Interest accrues on the loan; any outstanding loan balance, including accrued interest, will reduce the death benefit paid to beneficiaries if not repaid.

Another option is to make a withdrawal from the cash value. Policyholders can withdraw a portion of their cash value directly. Withdrawals reduce both the policy’s cash value and its death benefit. If the amount withdrawn exceeds total premiums paid into the policy (the cost basis), the excess is considered taxable income.

Policy surrender involves terminating the policy for its “cash surrender value.” This amount is the cash value minus any surrender charges. Surrendering a policy means losing death benefit coverage; any amount received exceeding total premiums paid will be subject to taxation.

Cash value can also pay future premiums. This feature is useful if a policyholder experiences financial hardship or wishes to reduce out-of-pocket premium payments. Utilizing cash value for premiums can help maintain the policy’s in-force status.

Tax Considerations of Cash Value

Cash value offers tax advantages distinguishing it from other investment vehicles.

A primary advantage is tax-deferred growth of the cash value. Earnings within the cash value, whether from interest, dividends, or investment gains, are not subject to current income tax. Taxes are deferred until money is accessed, allowing cash value to grow more efficiently.

Policy loans against cash value are tax-free. Borrowing from the policy’s cash value does not create a taxable event, assuming the policy remains in force and is not classified as a Modified Endowment Contract (MEC). If a policy becomes a MEC, loans and withdrawals are treated differently for tax purposes, potentially becoming taxable and subject to a 10% penalty if taken before age 59½.

Withdrawals from cash value are tax-free up to the amount of premiums paid into the policy. This is known as the “cost basis” or “return of basis.” Any amount withdrawn exceeding this cost basis is considered taxable income. This “first-in, first-out” (FIFO) tax treatment for withdrawals up to basis is a tax benefit.

If a policy is surrendered, any amount received exceeding total premiums paid is considered a taxable gain. This gain is subject to ordinary income tax rates. Compare the cash surrender value to total premiums paid to determine potential tax liability upon surrender.

The death benefit paid to beneficiaries is income tax-free. This applies whether the policy has cash value or not, providing a tax-efficient transfer of wealth to heirs. Consult a qualified tax professional to understand how these rules apply to individual circumstances.