Cash value

What is cash value?

When most people think about life insurance, they probably focus on the death benefit of the policy. The death benefit is the amount that is paid to the policy’s beneficiaries if the insured passes away. However, on some policies there is also a “cash value” that accumulates while the insured person is still living. This cash value can be accessed during the insured’s life. It is typically only available on permanent life insurance, and not term life policies.

How cash value works

As you pay premiums toward a permanent life insurance policy, part of the premium goes towards the cost of the insurance and the death benefit. But there’s another component, and that’s the cash value. The cash value is typically low in the first few years, but builds as premiums are paid.

Some policies are called whole life, which offers guaranteed cash value and may pay a non-guaranteed dividend on the cash value. Other policies are called universal life which have a cash value that grows at a guaranteed interest rate but  has the potential to grow at a higher rate depending on the performance of the insurer.

Cash Value: what’s it good for?

There are a number of common ways to use some of the money built up in the cash value component of a life insurance policy:

  • Partial Surrender: This is when a specific amount of money is directly withdrawn from the cash value account.
  • Full Surrender: This is when the policyholder effectively ‘turns in’ and cancels the policy in exchange for its cash value.
  • Policy Loan: This is when the policyholder borrows money from the insurance company against the cash value of the policy.
  • Paying Premiums: On universal life policies, it may be possible to use some of the cash value to cover the policy’s cost of insurance. On whole life policies, it may be possible to use the dividend to pay the policy’s premiums.
  • Increasing the Death Benefit: On universal life policies, policyholders can apply for an increasing death benefit where the cash value is added to the policy’s death benefit. On whole life policies, policyholders may be able to use the dividend to purchase additional death benefit.

Some things to keep in mind

If you do decide to access the cash value of your insurance policy in some manner, there are some issues you’ll want to consider. For one thing, a direct withdrawal of money from the cash value component of your policy may result in tax consequences-the amount withdrawn could count as income. Taxes aside, a partial surrender will usually mean that your death benefit is reduced. And of course, a full surrender has the effect of ending the policy completely-you will get the cash value but at the cost of your beneficiaries not receiving the death benefit.

In the case of a policy loan, the advantage is that the policy itself stays intact. However if the loan is not repaid it is generally deducted from the death benefit payable to the beneficiaries. There are some other details to be aware of, though. First, as with most loans, the insurance company charges interest on money borrowed against the cash value. Second, the tax issues can be somewhat complex, depending on the applicable tax laws. Also, depending on the size of the loan and growth in the cash value, some of the loan may be considered taxable income. If you are thinking of a loan option, it’s wise to consult a tax professional first.

Consumers should also be aware that in most cases, the cash value of an insurance policy is not paid to a person’s beneficiaries at the time of death. For instance, if the insured individual dies and they have a $500,000 policy plus $100,000 of accrued cash value, only the $500,000 will be paid out.

Finally, cash value insurance policies will not be for everyone. One of the reasons premiums are higher for permanent life policies compared to term insurance is because the former has the cash value element. Depending on your goals and situation, you may decide to go one route or the other.

Sources

  1. http://business.financialpost.com/investing/whole-life-insurance-can-improve-returns-reduce-risk
  2. http://www.advisor.ca/insurance/life/should-clients-cash-out-an-insurance-policy-204870
  3. https://www.investopedia.com/articles/personal-finance/082114/6-ways-capture-cash-value-life-insurance.asp

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Andrew Hepburn is a freelance writer based in Toronto who specializes in financial issues. He's written for Maclean's, Canadian Business, MoneySense, Morningstar and T.E. Wealth, among others.