Life insurance provides a death benefit for the policy's beneficiaries. Life insurance policies come in several forms, including cash value life insurance which provides permanent coverage with a savings component.
What Is Cash Value Life Insurance?
Cash-value life insurance is a form of permanent life insurance that contains a cash value savings component. The cash value is used in several ways by the policyholder. These include taking a loan against the policy's cash value, withdrawing it or using it to reduce the policy's premiums.
This differs from term insurance where the policyholder is buying pure insurance coverage in the form of a death benefit only. Term insurance is not permanent insurance, coverage runs for a set term such as 10, 20 or 30 years.
How Does Cash Value Life Insurance Work?
A portion of each premium payment goes towards the cost of the insurance coverage and a portion goes into an investment account. The money diverted the investment account earns interest, or investment income in the case of some types of cash value policies, building cash value inside of the policy over time. With some policies, some or all of the cash value can be used to purchase an additional death benefit as a paid-up addition.
If a loan is taken from the policy and some or all of it remains unpaid at the time of the policy holder's death, then the death benefit received by the beneficiaries of the policy will be reduced.
Types of Cash Value Life Insurance
There are several different types of cash value life insurance policies.
Whole Life Insurance
Whole life insurance covers you for your entire life as long as the premiums are paid. A portion of the premiums goes towards the cost of the insurance coverage and a portion goes toward building cash value within the policy. Some benefits of whole life insurance include:
- Premiums will not increase as long as the policy is in force.
- You will not be required to pass a medical exam once the policy is issued regardless of any changes in your health.
- The cash value of the policy may grow to be enough to cover the cost of the premiums over time.
- There are potential tax advantages while you are alive and for your estate after your death.
Universal Life Insurance
Universal life insurance is similar to whole life in that it is a form of permanent insurance with a cash value component.
Universal life policies generally have a flexible premium option, in fact, policyholders usually have the option to adjust both their premium and the policy's death benefit. The policy's cash value earns interest and can be accessed without impacting the policy's guaranteed death benefit.
Indexed Universal Life Insurance
An indexed universal policy allows the policyholder to allocate the cash value amounts from their premiums to either a fixed account or an investment account based on an index like the S&P 500.
Indexed universal life policies offer a death benefit with the opportunity to build tax-deferred retirement savings. IULs are often used as key-person insurance by businesses or as estate planning vehicles.
An IUL offers:
- Relatively low premiums
- A permanent death benefit
A couple of drawbacks include:
- They tend to work best with larger death benefits
- If the index declines, there may little or a nominal amount of interest credited to the cash investment account in the policy.
Variable Life Insurance
Variable life insurance is another form of permanent cash value life insurance with an investment component contained in the policy. The cash value account can be invested in several sub-accounts that are much like mutual funds.
The main appeal of universal life is the availability of the investment component of the policy and the fact that the cash value can grow tax tax-deferred. The cash value's growth will be dependent upon how well the underlying investment subaccounts perform.
What Are the Pros and Cons of Cash Value Life Insurance?
Cash-value life insurance has several pros and cons.
- As long as the premiums are paid and the policy is in force, the beneficiaries will receive a death benefit when the policyholder dies.
- The premium remains the same as long as the policy is in force, the payments are predictable. In some cases, the cash value built up inside the policy will eventually be sufficient to cover the premiums.
- The cash value is an asset. It grows over time as the premiums are paid and part of the premium payment goes toward building the policy's cash value. The cash value can be used in several ways by the policyholder.
- Some cash value policies pay a dividend. This will depend upon the insurance company and its performance.
- Tax benefits. The cash value of the policy grows on a tax-deferred basis.
- The premiums on cash value policies will be higher than those for term insurance with the same death benefit.
- The embedded fees inside the policy can be quite high, especially if you are looking to the policy as an investment vehicle. There are less costly ways to invest on a tax-deferred basis.
- Many of these policies are complex, be sure you understand what the policy does and doesn't do for you, and if you need all of the policy's features.
Should You Consider Cash Value Life Insurance?
The answer, like most financial planning-related questions, is that it depends.
If your need for life insurance isn't permanent, then you might consider a less costly term policy. For example, if you are looking for coverage while your children are young, then you might consider a 10- or 20-year-level term policy.
If you anticipate a permanent need for life insurance, for estate planning purposes for example, then a cash value life insurance policy might be the right solution. A cash value policy can also be useful when there is a business, a farm or some other relatively illiquid asset involved. The cash value policy can provide liquidity to your heirs and help cover estate taxes.