In life insurance cash value is money invested a tax-deferred account funded by premium payments. Cash value is common among all permanent life policies. However, the way cash value builds and how it can be withdrawn differs by life insurance type. Sometimes “cash value” is used synonymously with “surrender value” or “policyholder’s equity”.
Here are some key facts about cash value and life insurance:
- Permanent life insurance policies have “fixed” death benefits, sometimes called face value, as well as investment benefits called cash value.
- Typically the cash value part of your life insurance grows slowly at first, focuses on funding death benefits, but over-time the amount of premiums contributed toward the fund increase as do returns.
- The amount of money you pay toward your cash value in premiums is called your “basis”. Withdrawals aren’t taxable up to your “basis”.
- Cash value grows tax free, but you may owe taxes on it when you withdraw. Whether or not you are taxed depends upon your policy, when you withdraw, and your basis.
- Some types of life insurance classified as modified endowment contracts (MEC) require you to wait until 59 1/2 to withdraw money or pay a penalty (up to 10% early withdrawal like a 401k).
- Penalties often include being taxed, a fixed penalty amount, and/or a reduction of death benefits. Double check your contract before withdrawing funds.
- Cash withdrawals that reduce your “surrender value” (the amount you are owed if the policy is terminated before an event) could cause your premiums to increase for the same death benefits. This could cause unaffordable premiums leading to a policy lapse.
- There are a number of different methods for withdrawing funds. You can use funds to pay premiums, convert your policy, or sell your policy. Each has it’s own pros and cons.
- Withdrawing money from your cash value can reduce death benefits.
- The investment fund portion of the account is run differently for each type of permanent life policy, it’s important to understand who is in charge of managing your funds and how money is invested.
- Understanding how the investment portion of permanent life insurance builds cash value, and how that cash value can be withdrawn, is the key to getting the most out of any “whole life” policy.
How Does Cash Value Work?
Typically cash value builds in a tax-advantaged investment fund (sometimes referred to as a savings account) attached to permanent or whole life insurance policies. That means your money grows tax free until you take it out or it pays out. When it pays you’ll owe money on the taxable gains you made, but not the premium dollars you invested. Depending upon the life insurance type there will be different rules for how investments are managed, how the account is regulated, how pay-outs work, how premium payments work, and how the money is taxed.
Types of Cash Value in Life Insurance
There are a number of different types of life insurance, each type offers a unique structure of death benefits and investments. In some types of life insurance investments are managed by the insurer, in others the insured gets more control.
The chart below shows the four most common life insurance types and how cash value builds differently in each.
The Longer You Hold the Policy the Better Cash Value Builds
Typically the longer you pay into a life insurance policy the larger percentage of the larger the percentage of the premium that is allocated to the investment fund and the better returns you get.
Cash Value Versus Death Benefits (Face Value)
A “Death benefit” (AKA face value) is the amount that is paid out when the policy holder dies. This is typically a fixed sum. “Term” life insurance typically only pays out in “death benefits” while “whole” life insurance typically includes both death benefits and in cash value built over the duration of the policy.
How Withdrawing Cash Value Works
Like with other aspects of cash value, the tax implications and penalties for withdrawing money differs by insurance type. Generally however, the insured can withdraw money from an investment account that has built cash value starting at age 59 1/2 with no or reduced penalties.
Options for withdrawing “cash value” include:
- Partial withdrawals
- Policy loans
- Cashing in the policy and letting it lapse
- Trading your policy for an annuity or long-term-care policy
- Selling your policy to a life-settlement company
Policy and Tax Implications of Cash Value
When you pay into a life insurance investment fund that builds cash value your investments can grow tax free. However, depending upon how you withdraw cash value you can still owe taxes on the money when you take it out. Like a retirement account there can be additional penalties beyond taxes for withdrawing the money early or in the wrong way.
All the money aside from the amount you paid in in premiums has not been taxed yet. So when you withdraw money in any way you should expect to owe some sort of tax on it.
The amount the policy will pay out in death benefits and other things like premium payments can be affected by withdrawing money from your account, so make sure to understand all implications before you withdraw money or convert the policy in anyway.
Options for Converting Cash Value to Other Assets
Here are the tax implications and penalties for taking money out of a life insurance investment fund or converting those assets:
Premium money withdrawn early. You don’t owe taxes on any amount you withdraw paid by premium dollars you already contributed, known as your “basis” (you had to pay taxes on that money in the first place before you invested it). However, may owe penalties defined by contract.
Non-premium money withdrawn early. You’ll owe the full tax amount (dependent upon your taxable income) plus the penalty amount defined in your contract (which can come in the form of reduced death benefits).
Use cash value to pay premiums. You can simply use your cash value to pay premiums if money is tight.
Take a loan to pay premiums. If you are having trouble paying premiums because cash is tight you can take a tax-free loan by borrowing against your policy. This is a last resort and should only be used if you can safely assume you will pay the loan back in a short amount of time. The amount you don’t pay back will be deducted from death benefit payouts when you die. This is a loan from the insurer at an interest rate, not a withdrawal from your cash value. You can use cash value to pay back the loan, however your policy is used as collateral. This means your interest from the loan could technically exceed your interest can cause the policy to lapse. If your policy does lapse, you’ll owe taxes on the amount of the cash value, including loans that exceed the premiums you paid in. Learn more from kiplinger.com
Convert your policy. You can convert a whole life policy through a 1035 exchange (a tax-free exchange of an existing annuity contract for a new equivalent annuity contract). In short this means you’ll lose death benefits, keep cash value, and won’t owe premiums anymore. You can compare payouts at www.immediateannuities.com. There are a number of options for conversion into other types of policies, some of them like long-term-care insurance (which is not taxable meaning you’ll never pay taxes on your gains!).
Sell your policy (life settlements). You can sell your policy to an investor or investment firm. Essentially a life settlement company will buy your policy. This means you won’t owe premiums and won’t get death benefits. Instead the investor will continue to pay your premium and collect the policies cash value and death benefits. The better deal it is for the investor the more likely they will pay what the policy is worth, a younger healthier policy holder will have a hard time finding a life-settlement company to buy their policy.
Reasons Not to Sell Your Life Insurance Policy or Withdraw Cash
The longer you keep an account, the better returns it offers. Given this it can be a bad move to surrender a policy unless you know you need the money. Consider using the funds in the account to pay premiums if things are tight. We don’t suggest taking a loan or selling off your policy, but do suggest withdrawing money that won’t be penalized by the contract when needed. Remember everyone involved with your policy from the agent who sold it to you, to the insurer, to those who would buy your policy or convert it, operate for profit. Focus on the needs of your family and what rate you’ll be taxed at this year and make smart long term decisions in regard to your policy.