Is Cash Value of Life Insurance a Liquid Asset?

Life insurance policies offer financial protection, with some types including a cash value feature. This cash value can grow over time, leading many to question its accessibility and classification as a liquid asset. Understanding how cash value can be accessed is important for policyholders considering its role in financial planning. This article explores the characteristics of cash value life insurance and its liquidity.

Understanding Cash Value Life Insurance

Cash value life insurance is a category of permanent life insurance policies that build a monetary component over time. Unlike term life insurance, which provides coverage for a specific period, permanent policies like whole life and universal life are designed to last for the policyholder’s entire life. A portion of each premium paid into these policies contributes to this accumulating cash value.

The cash value within these policies grows differently depending on the specific type. Whole life policies offer a guaranteed cash value accumulation at a fixed interest rate. Universal life policies accumulate cash value based on current interest rates, which can fluctuate, though they have a guaranteed minimum rate. Variable universal life policies allow the cash value to be invested in various sub-accounts, similar to mutual funds, where growth or decline is tied to investment performance. This accumulated cash value is distinct from the policy’s death benefit, the amount paid to beneficiaries upon the insured’s passing.

Methods of Accessing Cash Value

Policyholders can access the cash value in their permanent life insurance policies through several methods.

A policy loan is one approach, where the cash value serves as collateral. These loans are available without a credit check or formal approval, and the policy remains in force. Interest accrues on the loan, and any outstanding loan balance, including accrued interest, reduces the death benefit paid to beneficiaries if the insured passes away before repayment.

Withdrawals, also known as partial surrenders, are another method. Withdrawals reduce the policy’s cash value on a dollar-for-dollar basis and can also diminish the death benefit. Unlike loans, withdrawals permanently remove funds from the policy’s cash value. Policyholders do not have a repayment obligation for withdrawals, but this action can impact the policy’s future performance and its ability to remain in force.

Surrendering the policy entirely for its cash surrender value is a third option. This means terminating the insurance coverage. In exchange, the policyholder receives the accumulated cash value, minus any applicable surrender charges. This action results in the complete forfeiture of the death benefit, as the policy ceases to exist. Surrender charges, which can be substantial, especially in the early years, are deducted from the cash value before payout.

Tax Implications of Accessing Cash Value

Accessing the cash value of a life insurance policy carries specific tax implications that vary by method. Policy loans are considered tax-free transactions, provided the policy remains in force and the loan is repaid. However, if the policy lapses or is surrendered with an outstanding loan, the borrowed amount exceeding the policy’s cost basis (total premiums paid) may become taxable as ordinary income.

Withdrawals from the cash value are tax-free up to the amount of premiums paid into the policy, known as the “cost basis.” Any amount withdrawn exceeding this cost basis is considered taxable income and is taxed at ordinary income rates. This is because the growth within the cash value is tax-deferred, and the portion representing earnings becomes taxable upon withdrawal beyond the initial investment.

When a policy is surrendered, any amount received by the policyholder that exceeds the total premiums paid (cost basis) is subject to taxation as ordinary income. This taxable gain represents the investment growth within the policy. If a policy is classified as a Modified Endowment Contract (MEC) due to overfunding, any loans or withdrawals are treated differently, with earnings taxed first and subject to a 10% penalty if the policyholder is under age 59½.

Assessing Cash Value as a Liquid Asset

The cash value of a life insurance policy can be considered a liquid asset because it can be accessed and converted into cash while the policyholder is still living. Funds can be accessed relatively quickly, within a few business days to a few weeks, depending on the insurer and access method. This accessibility provides a source of funds for various financial needs.

However, several factors affect its effective liquidity. Accessing the cash value involves certain costs or impacts, such as interest charges on loans, reduction of the death benefit, or the imposition of surrender charges, particularly in the early years. While more accessible than illiquid assets like real estate, cash value is not as instantly liquid as funds held in a checking or savings account. The process and consequences of accessing cash value mean it functions differently from highly liquid bank deposits, which have no penalties for withdrawal.