How Does Whole Life Insurance Cash Value Work? A Guide to Understanding and Using Your Policy's Savings Component

 

Whole life insurance is a type of permanent life insurance that provides coverage for your entire life and also builds cash value over time. Whole life insurance can be a good option for people who want to leave a legacy for their loved ones, create a tax-advantaged savings account, or protect their estate from taxes and creditors. However, whole life insurance is also one of the most expensive types of life insurance you can buy, and it can be complicated to understand and compare.

One of the most confusing aspects of whole life insurance is the cash value component. What is cash value and how does it work? How can you access it and use it for your benefit? What are the risks and limitations of cash value? In this article, we’ll answer these questions and more. We’ll explain how cash value works and how to use it effectively.

What Is Cash Value and How Does It Grow?

Cash value is the savings account within a whole life insurance policy that accumulates over time. Cash value is one of the main features and benefits of whole life insurance, as it provides a living benefit for policyholders.

When you buy a whole life insurance policy, you pay a fixed premium every month or year. A portion of each premium payment goes into the cash value account and earns a fixed rate of interest. The interest rate is guaranteed by the insurer and is usually higher than the average savings account rate.

The cash value grows tax-deferred, which means you don’t have to pay taxes on the interest or gains until you withdraw or surrender the policy. The cash value is also guaranteed by the insurer, which means you won’t lose money if the market goes down or the insurer goes bankrupt.

To illustrate how cash value can grow over time, let’s look at an example. Suppose you buy a whole life insurance policy with a $100,000 death benefit and a $1,000 annual premium at age 30. The policy has a 4% guaranteed interest rate on the cash value. Here’s how your cash value would grow over time:

Age	Cash Value
30	$0
40	$5,728
50	$16,367
60	$34,719
70	$65,233
80	$115,955

As you can see, your cash value grows slowly at first, but faster as you get older. This is because of compound interest, which means you earn interest on your interest. By age 80, your cash value would be more than your death benefit.

How Can You Access Your Cash Value?

Cash value is not only a savings account, but also a source of funds that you can access and use for various purposes. There are different ways to access your cash value, such as withdrawals, loans, or surrender. However, each option has its pros and cons, and may affect your death benefit, taxes, or fees.

Withdrawals

You can withdraw money from your cash value account at any time, up to the amount of your basis. Your basis is the total amount of premiums you’ve paid into the policy. For example, if you’ve paid $10,000 in premiums over 10 years, your basis is $10,000.

Withdrawals are tax-free up to your basis. However, if you withdraw more than your basis, the excess amount is taxed as ordinary income. For example, if you withdraw $15,000 from your cash value account and your basis is $10,000, you’ll have to pay taxes on $5,000.

Withdrawals also reduce your death benefit by the amount you withdraw. For example, if you have a $100,000 death benefit and you withdraw $15,000 from your cash value account, your death benefit will be reduced to $85,000.

Withdrawals may also incur fees or charges from the insurer, depending on the policy terms and conditions. For example, some policies may charge a withdrawal fee of $25 or a percentage of the withdrawal amount.

Loans

You can borrow money from your cash value account at any time, up to the maximum loan value. The maximum loan value is usually a percentage of your cash value, such as 90% or 95%. For example, if you have a $20,000 cash value and a 90% maximum loan value, you can borrow up to $18,000.

Loans are tax-free and do not reduce your death benefit. However, you have to pay interest on the loan amount. The interest rate is usually set by the insurer and may be higher or lower than the interest rate on your cash value. For example, if your cash value earns 4% interest and your loan charges 6% interest, you’ll have a net loss of 2% on your loan.

Loans are not required to be repaid, but they will reduce your death benefit by the outstanding loan balance plus interest. For example, if you have a $100,000 death benefit and you borrow $18,000 from your cash value account at 6% interest, and you die after one year without repaying the loan, your beneficiaries will receive $81,080 ($100,000 - $18,000 - $1,080).

Loans may also incur fees or charges from the insurer, depending on the policy terms and conditions. For example, some policies may charge a loan origination fee or an annual service fee.

Surrender

You can surrender your policy and receive the cash surrender value at any time. The cash surrender value is the amount of money you’ll receive after deducting any fees or charges from your cash value. For example, if you have a $20,000 cash value and a $500 surrender charge, your cash surrender value is $19,500.

Surrendering your policy is taxable to the extent that your cash surrender value exceeds your basis. For example, if you surrender your policy and receive $19,500 in cash surrender value and your basis is $10,000, you’ll have to pay taxes on $9,500.

Surrendering your policy also terminates your coverage and forfeits your death benefit. For example, if you surrender your policy with a $100,000 death benefit and receive $19,500 in cash surrender value, you’ll lose the remaining $80,500 in potential death benefit.

How Can You Maximize Your Cash Value?

Cash value can be a valuable asset for your financial security and flexibility. However, not all cash value policies are created equal. Some policies may offer higher returns, lower costs, or more options than others. Here are some strategies to maximize your cash value growth and benefits:

• Buy a policy early in life. The younger you are when you buy a whole life insurance policy, the lower your premiums will be and the longer your cash value will have to grow. You’ll also lock in your insurability and avoid the risk of being denied coverage or paying higher rates due to health issues later in life.

• Pay higher premiums or make additional payments. The more money you put into your cash value account, the faster it will grow and the higher your death benefit will be. You can pay higher premiums than the minimum required by your policy, or make additional payments on top of your regular premiums. However, you should be careful not to exceed the IRS limits on cash value contributions, as this may trigger taxes or penalties.

• Choose a participating policy that pays dividends. Some whole life insurance policies are participating, which means they share the profits of the insurer with the policyholders in the form of dividends. Dividends are not guaranteed and vary by year and insurer, but they can be a significant source of income and growth for your cash value. You can use your dividends to reduce your premiums, buy paid-up additions (extra coverage that increases your cash value and death benefit), accumulate interest, or receive cash.

• Add riders that enhance your cash value. Some riders can help you increase your cash value or access it more easily. For example, a paid-up additions rider allows you to buy extra coverage with your dividends or additional payments, which increases your cash value and death benefit. A guaranteed insurability rider allows you to increase your coverage amount at certain intervals or life events without having to undergo another medical exam or provide proof of insurability, which also increases your cash value and death benefit.

What Are the Risks and Limitations of Cash Value?

Cash value is not without its risks and limitations. Some of the drawbacks of cash value include:

• The high cost of whole life insurance compared to term life insurance. Whole life insurance is much more expensive than term life insurance because it provides lifetime coverage and cash value accumulation. You may end up paying more in premiums than you’ll ever receive in cash value or death benefit. You may also miss out on other investment opportunities that could offer higher returns or lower risks than cash value.

• The possibility of losing your cash value if you lapse or surrender your policy. If you stop paying your premiums or surrender your policy, you’ll lose your coverage and forfeit your cash value (minus any fees or charges). You may also have to pay taxes on any gains in your cash value if you surrender your policy.

• The tax consequences of withdrawing more than your basis or surrendering your policy. If you withdraw more than the amount of premiums you’ve paid into your policy, or if you surrender your policy, you’ll have to pay taxes on the excess amount as ordinary income. This could reduce your net cash value significantly.

• The restrictions on accessing your cash value imposed by the insurer or the IRS. You may not be able to access your cash value as easily or as much as you want, depending on the policy terms and conditions and the IRS rules. For example, some policies may limit how much or how often you can withdraw or borrow from your cash value, or charge fees or interest for doing so. The IRS may also limit how much you can contribute to or withdraw from your cash value without triggering taxes or penalties.

Conclusion

Cash value is a unique feature of whole life insurance that provides a living benefit for policyholders. Cash value is a savings account within a whole life insurance policy that grows over time with a guaranteed interest rate and tax-deferred status. Cash value can be accessed and used for various purposes, such as paying for emergencies, education, retirement, or premiums.

However, cash value is not a simple or cheap option. Cash value is complex and costly to understand and compare. Cash value also has its risks and limitations, such as high premiums, low returns, tax implications, and access restrictions.

If you’re interested in buying whole life insurance with cash value or learning more about it, don’t hesitate to contact us today. We can help you get a free quote from top-rated insurers and answer any questions you may have about cash value.