THE VALUE OF WHOLE LIFE CASH VALUE
The cash value of a whole life insurance plans is one of the key factors that differentiate it from other types of life insurance plans. Read on to learn what cash value is and how it could come in handy later on down the road.
Chances are you’ve heard of the concept of “cash value” in relation to whole life insurance. That makes sense, of course, considering the concept is unique to whole life insurance.
Whole life is generally more expensive than term life insurance. Part of this added cost is due to the policy being in place longer and the guarantee that it will pay out. Some of this additional cost is also dedicated to building up the cash value of the policy, too.
But just what is cash value, and what benefits does it bring to owners of whole life insurance policies?
Accumulated cash value gives whole life policyholders a few added options that can’t be found in simpler term life insurance policies.
Read on to learn more about what cash value is, what options cash value brings to whole life policyholders, and if cash value makes whole life insurance an effective and smart investment.
UNDERSTANDING CASH VALUE
When you pay your insurance premiums, a portion of that money goes toward your cost of insurance. Another bit of the premium pays for insurer overhead and fees. Whatever’s left over is directed to the policy’s cash value.
When you’re younger, the cost of insuring you is lower. That’s because it’s less likely your beneficiary will soon be filing a death claim. In other words, the insurer will have more time to earn a profit from you owning a policy.
This also means more of your premium will be directed to the cash value portion. As you get older, the amount your premium contributes to the cash value shrinks, though your cash value will continue to grow.
Cash value grows the same way a savings account does — through interest, with a guaranteed interest rate determined by the insurer. In fact, whole life insurance is like a forced savings account when considering cash value.
Over time, as you put more money into the policy, your cash value will start to accumulate faster. Even though your premium is contributing less to the cash value, interest will grow on a larger amount of money.
And guess what? Unlike the savings account at your local bank, cash value grows tax-deferred. You’ll never be taxed on your cash value unless you access it in some specific circumstances (more on that later).
CASH VALUE IS DIFFERENT THAN THE FACE VALUE OF A POLICY
Don’t confuse cash value with the term “face value.” The face value of your policy is simply its death benefit — how much it will pay out to your beneficiary upon your death. Left alone, cash value doesn’t impact the face value of your policy.
In this way, cash value is essentially a living benefit of whole life insurance. It’s something you can access and use while you’re alive. Whole life insurance affords you more options compared to term life.
As with a traditional savings account, you can access your cash value for any reason. Of course, however, there are some caveats — as well as advice you should adhere to.
Let’s talk about the various ways cash value can be used and what living benefits it provides you.
HOW CAN CASH VALUE BE USED?
Insurers often boast of the benefits of cash value as a selling point for whole life insurance. But exactly how can you use the cash value you accumulate over the life of a policy?
Cash value can be used:
- As a loan against your policy
- To pay your premiums
- To purchase a paid-up policy
- To increase your death benefit
- To withdraw cash from your cash value
If you have a whole life policy, these options give you a number of ways to maximize the policy’s potential. It’s these options that make whole life insurance an investment in addition to a viable method for insuring your life.
Let’s look at each option in detail for how cash value can serve you.
USE YOUR CASH VALUE AS A LOAN
Everyone has the need for a little extra cash now and again. Perhaps you’re out of work and need to supplement your disability insurance for awhile. Or maybe you want to surprise your significant other with a vacation or anniversary gift.
Whole life insurance allows you to access your cash value in the form of a loan. While the loan does accrue interest, the rate is often lower than what a bank would offer you.
Oh, and there’s no impact to your credit report! In fact, you can use your cash value as a loan no matter how bad your credit is. That’s because it’s your money.
You don’t even need to pay the loan back if you don’t want to (or can’t).
Of course, there’s a downside. Loaning from your cash value decreases the death benefit of your policy until the loan is paid back.
If you have a $40,000 death benefit and take out a loan for $10,000 and never repay it, your beneficiary would receive less than $30,000 upon your death (accounting for the unpaid loan interest, as well).
PAY YOUR PREMIUMS WITH YOUR CASH VALUE
Even though your life insurance premium should be part of your budget, life doesn’t always go according to plan. Sometimes, the cost of life insurance might simply be too prohibitive for you to continue paying.
That doesn’t mean you need to abandon your policy, though. (Doing so should only ever be considered a true last resort.)
Instead, you can pay your premiums by directing your insurer to take their cost from your cash value. This is a particularly sound strategy later in life, when your cash value has accumulated a large amount.
You’re always free to resume making premium payments yourself, too. If you ever do choose this route, however, ensure that your cash value doesn’t run out. If it does, your policy may lapse.
PURCHASE A REDUCED PAID-UP POLICY
Your financial situation is likely to change as you age. You might find your whole life policy provides more coverage than you need — or can afford. Or, you may have decided it’s best used for something other than what you originally purchased it for.
Maybe you’d like it to cover your funeral expenses only and no longer be left behind as a gift. You may also be consolidating your expenses and looking to drop insurance premiums.
You can use your accumulated cash value to purchase a paid-up whole life insurance policy. This option will take your cash value to purchase as much life insurance as it affords, trading in your current policy for a policy with a smaller (reduced) death benefit — and no associated premiums.
It’s a great way to stay insured without any financial obligation. After all, some insurance is always better than no insurance, and a reduced paid-up policy adheres to that philosophy.
INCREASE YOUR DEATH BENEFIT WITH CASH VALUE
The cash value of a whole life policy isn’t added to its death benefit upon your death. Your beneficiary will receive only the policy’s face value; the insurer will receive the cash value.
That is, of course, unless you simply...ask.
The cash value is money you’ve put into the policy. Over time, it can become a substantial amount, but it’s a waste if you pass away leaving it untouched. Your investment in the policy should be rewarded somehow, right?
Some insurers may allow you to exchange your cash value for a larger death benefit. This is accomplished by simply speaking to your agent or calling your insurer and asking for it.
Increasing your death benefit by using your cash value isn’t always guaranteed. It’s dependent on your specific insurer and circumstances. Still, making the request is worth a shot. Chances are the insurer won’t want to risk losing your business and will honor your request.
Using your cash value ensures your beneficiaries, not the insurance company, appreciates the insurance investment you’ve made.
WITHDRAW ALL OR SOME OF YOUR CASH VALUE FOR CASH
As mentioned earlier, the cash value portion of whole life insurance is like a forced savings account. Money accumulates and grows over time, but it’s always your money.
You can withdraw all or some of your cash value for cold, hard cash. If you withdraw only as much as you’ve put into the policy, the money is tax-free; you’ve already been taxed on it, after all.
This portion of the cash value is called the “cash basis.” The cash basis is equivalent to the money you’ve paid into the policy, via premiums, with after-tax dollars (meaning you’ve already paid taxes on that money).
If you withdraw over what you’ve paid in (for example, if your cash value has exceeded premiums paid in via interest on investments made by your insurer), any amount over what you’ve paid into the policy is subject to tax.
Withdrawing a portion of your cash value will reduce your policy’s death benefit by the same amount. So if you have a policy with a $100,000 death benefit and make a partial withdrawal of $40,000, you’ll reduce your death benefit down to $60,000 (or less, depending on any fees or penalties your insurer may charge).
Withdrawing all of your cash value is called a policy surrender. The insurer will cut you a check for the policy’s total cash value in exchange for ending your coverage.
A full surrender of your policy may subject you to fees and penalties, especially if you surrender it within the first two or three years of owning the policy. Any cash received over the cash basis of the policy will be treated as income tax, as well.
WHOLE LIFE INSURANCE AS AN INVESTMENT STRATEGY
Is whole life a smart investment strategy, considering the benefits of cash value?
That depends on a variety of circumstances specific to your situation and tolerances.
You may have heard the advice to, “buy term and invest the rest.” For most, this is an effective strategy...if you manage to stick to it.
The problem is, most people tend to spend the difference without properly investing it. Their term policy will lapse and they’ll be left with no life insurance coverage or alternate means of protecting their loved ones following their death.
Traditional investments are also volatile compared to whole life. Whole life cash value grows at a guaranteed rate; investments rise and fall with the market. The trade-off, of course, is that whole life cash value grows slowly and at a smaller rate compared to riskier investments.
If you’re confident in your discipline, however, the best rate-of-return is generally to buy a term life policy and invest the difference. You should also contribute the difference toward retirement accounts, such as your 401(K) or IRA.
If you’ve maximized your retirement accounts, a whole life policy may serve you well — especially if you’re wealthy enough to where estate taxes are likely to become a worry.
Of course, there’s nothing stopping you from buying both term and whole life policies. There’s no cap on how much life insurance you can have — you’re limited only by affordability. You can purchase a term life policy with a substantial death benefit to cover you during your prime earning years, and a small whole life policy to build up cash value over time.
SHOULD YOU USE WHOLE LIFE INSURANCE AS PART OF AN INVESTMENT STRATEGY?
So how smart an investment strategy is whole life insurance? It’s certainly not a dumb strategy, but it may not be the most effective strategy for you, either.
In the end, what factors play a role are:
- Your needs and wants
- Your risk tolerance
- And your budget
Compare whole life and term life insurance quotes to get a general idea of which works best for your budget and needs. Then, consult a reputable financial planner to further explore creating an investment strategy that utilizes life insurance to serve your purpose.
In the end, what matters most is having an investment strategy in place that works for you and your loved ones.