How does cash value life insurance work?

Cash value life insurance is a policy that contains an account that builds value (“cash value”) over time. It works by taking a part of your premium payment and putting it into to the account.

Depending on the policy type, the cash value can make investment gains based on a fixed percentage increase, on stock market gains or another method. You can take withdrawals or loans from the cash value. You can use the money for anything, such as:

  • Unexpected bills.
  • A child’s college tuition.
  • To supplement retirement income.

Which life insurance policies have cash value?

Whole life insurance: The cash value in whole life insurance grows at a guaranteed, expected rate of return. It's good for someone who wants no surprises with cash value growth.

Indexed universal life insurance: The cash value gains for indexed universal life insurance policies are linked to an index such as the S&P 500. It's for someone who wants to participate in the financial markets and is open to some risk with the cash value, meaning it can lose value.

Variable universal life insurance: The cash value growth (or loss) is tied to "sub-accounts" for which you pick your own investments, such as stock or bonds. It's for people who want to actively manage the investments and who are OK with a risk of losing their cash value.

Not all life insurance policies have cash value. These don't:

  • Term life insurance
  • Guaranteed universal life

Life insurance sales

Can I withdraw money from my universal life policy?

You can generally withdraw money from an indexed universal life or variable universal life policy -- assuming you have money within the cash value account.

Guaranteed universal life policies usually don’t have a cash value account.

What happens to the cash value of a whole life policy at death?

The cash value of a whole life insurance policy generally reverts back to the insurance company when the insured person dies.

But many universal life insurance policies offer a choice of what kind of death benefit your beneficiaries will receive. Three common options are:

  1. Open 1: Total face amount - Beneficiaries receive the policy “face value” (minus any partial withdrawals and any outstanding loans and the loan interest accrued). For example, if someone had a $500,000 policy with $25,000 in cash value, the beneficiaries get $500,000.
  2. Option 2: Total face amount plus cash value value - Beneficiaries receive the “face value” plus the cash value. For example, if someone had a $500,000 million policy with $25,000 in cash value, the beneficiaries get $525,000. Any unpaid policy loans and interest on the loans are deducted.
  3. Option 3: Total face amount plus premiums paid - Beneficiaries receive the face value plus the amount of premiums that had been paid (minus any withdrawals or loans and loan interest). This is much like getting a refund on premiums paid.

Cash value and death benefit options for life insurance

Is cash value life insurance a good investment?

Cash value life insurance can be a way to supplement other investment types you’ve maxed out, such as 401(k) retirement savings. But policy charges can significantly eat into the money that would otherwise go to cash value. Make sure you understand all the policy charges before you buy.

For example, a John Hancock indexed universal life insurance policy we examined had a policy charge of 35% in the first 10 years of the policy, and 32% in years after that. This is deducted straight from all premium payments. And that’s in addition to other charges, such as a monthly administrative charge, a monthly “face amount charge,” a monthly “cost of insurance” charge, an “indexed performance charge” and other fees. Whatever is left goes to the cash value component.

Why is cash value life insurance bad?

Some people view cash value life insurance as bad because of the amount of money that goes toward policy charges and not cash value. So if you need life insurance coverage only to provide a safety net for your family for specific debts, such as a mortgage, term life insurance probably fits the bill better. With term life you pay only for life insurance coverage.

But cash value life insurance serves a purpose for people who want both lifelong insurance and an extra investment vehicle.

Can you cash out a life insurance policy?

If you have a life insurance policy with cash value, you can “cash it out.” Cashing out terminates the policy.

But cashing out life insurance doesn’t mean you’ll get 100% of the cash value. You’ll generally receive the cash minus a surrender charge, if there is one, and get what’s known as the “surrender value.”

Cash value life insurance often has a “surrender period,” such as 10 years. After that there’s no surrender charge for cashing out. Check your policy for the surrender period.

What are the tax consequences of cashing in a life insurance policy?

If you cash out a life insurance policy, any investment gains you receive will be taxed as ordinary income.

The portion you receive that’s based on premiums you paid in is not taxable, only the investment gain portion.

If the cash value stays in the policy and doesn’t ever pass into your hands, it’s not taxable.

How much can I borrow against my life insurance policy?

You can typically borrow whatever amount is in the cash value account of a life insurance policy.

You can repay the loan any time. If you repay it, the insurer will also charge interest. For example, a Lincoln National universal life insurance policy we examined had a 4% annual loan interest rate.

If you don’t pay the loan back before you die, the loan amount and interest is deducted from the death benefit, and your beneficiaries receive less.