How the cash value of life insurance works

Cash value life insurance is a type of permanent life insurance.

Your premium pays for two functions:

• A death benefit for your family that is generally income-tax free.¹
• A balance held in a cash value account that acts as a savings/investment vehicle.

The type of permanent life insurance you buy will affect how quickly your cash value accumulates. The interest and earnings of your cash value will grow tax-deferred until you use the funds.

Three common types of permanent life insurance policies with cash value are whole, universal and variable universal. Each life insurance policy provides a tax-advantaged death benefit¹ and accumulates cash value in a different way.

Whole life insurance is the most common and basic type of cash value life insurance. In exchange for premium payments, you get a death benefit and cash value that grows at a guaranteed interest rate.

It also offers:

• Lifetime coverage (as long as premiums are paid).
• Premium payments that are guaranteed not to change.
• The potential for dividends.
• The option to add riders.
  

Universal life insurance is a type of cash value life insurance that has additional flexibility built in. Your cash value account typically earns a market rate of interest.

It also offers:

• Lifetime coverage, unless you don’t provide enough funding for the contract to remain active, or in force.
• The flexibility to change the amount or timing of your premium payments. You can speed up or slow down how much you're paying.

Note: You’ll want to be mindful if you decide to slow down contributions. When you reduce premium payments, you also may decrease the cash value of your life insurance or decrease the death benefit available to your beneficiaries.

Variable universal life insurance is one of the most feature-rich cash value insurance options. It functions similarly to universal life except that you can influence the growth of your contract’s cash value by choosing subaccounts to invest it in. This gives your cash value the potential to grow more quickly, but also incur more risk. Simply put, your cash value and death benefit may decrease if your investments do not perform well.

It also offers:

• Protection for a lifetime, as long as the contract retains its value.
• A mix of diversified investment options to choose from.
• Adjustable premium payments. You even can skip a payment when money is tight.

Similar to universal life insurance, you’ll want to be mindful if you decide to slow down contributions. If you stop or reduce your premiums and the cash surrender value is depleted, your contract might lapse and your coverage could end.

The best type of life insurance for you greatly depends on your financial goals and priorities.

In a nutshell, term life insurance helps provide simple protection during a set period of time—typically between 10 and 30 years. That's why cash value life insurance generally costs more than term life insurance. Cash value life insurance gives you protection throughout your life as long as you provide adequate funding and your contract retains its value.

You may want to start by evaluating a term policy against a permanent policy, and then decide what’s right for you.

Should you choose term or permanent life insurance?

Once you have decided to purchase life insurance, an important decision awaits you—choosing between term vs. permanent life insurance. To make the right choice for you, it's important to understand the benefits of each type of life insurance.


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The cash surrender value of a life insurance policy is determined by the:

• Amount of premiums paid.
• Length of time the policy has been in force.
• Size of your death benefit.
  

Your exact cash surrender value calculation will depend on the insurer you choose. In some cases, you can customize the balance between cash accumulation and death benefit as you open a policy.

Keep in mind that, when you pay an insurance premium, the money goes three places: the death benefit, the cash value and the insurer’s cost of doing business.

While permanent life insurance mainly offers protection through its death benefit, its cash value provides a number of opportunities to help you achieve your financial goals. Here are four common ways policyholders choose to leverage it.

When it’s time for the kids to head off to college, you may need cash reserves to help out. You can access the available cash value of a life insurance policy to pitch in toward education.

Supplemental income for retirement can come from the cash value of a life insurance policy, making it an important consideration alongside your other retirement income sources.

Imagine you took out a permanent contract in your 30s and stayed current with premium payments until you retired at age 67. Assuming your cash value increased during those 37 years, you could receive payments from the contract's cash value as a supplement to other retirement income. And a portion of those payments potentially would be tax-free.

Maybe someone bought cash value life insurance for you while you were young. Now that you’re older and ready to buy a home, you may have cash value money in the policy available to put toward a down payment. Before you access the cash value, be sure to calculate how much life insurance you may want to retain. Some people choose to keep their death benefit active at the coverage level they need and access the remainder of the cash value.

Your car breaks down, or a medical bill disrupts a financial goal. The available cash value policy is yours, and you can access it should you need it.

When you access the cash value of your life insurance contract, you’ll reduce your death benefit. You also may have to pay fees or taxes, so it's best to talk with your tax advisor and financial advisor before you take action. You’ll also probably have to wait at least 10 years after opening a policy to access the cash value that may have become available. Any sooner and your life insurance may lapse. The funding needed to keep a contract active may change after removing cash value.

But if you're eligible and decide you want to tap into that cash value, you have three options: withdrawals, loans and full surrenders.

Many policies allow you to take a tax-free withdrawal up to what’s known as your basis or cost basis. The basis is the total of all the premiums you have paid—minus any previous withdrawals and dividends received. You already paid income tax on your money, so you won’t be taxed again. However, your death benefit may be permanently reduced by the amount of your withdrawal.

Let’s use Robin as a hypothetical example. Robin bought a whole life insurance policy when she was 32 years old. She’d just had her first child and was in a high tax bracket. She liked the idea of using a cash value policy to continue protecting her assets. Every month, she paid her premium.

Today, Robin is 58 years old. Her home is now paid for and she is no longer financially responsible for her children. Her financial priorities have changed and she wants to use the policy's cash value to supplement her retirement income. She decides to withdraw some of the money, which lowers her death benefit. At tax time, Robin will pay income tax on any cash distributions greater than the sum of premiums she’s paid through the years.

Note that the withdrawal Robin made has now reduced the cash value of her life insurance, though any cash value remaining inside the contract still is tax-deferred. Restoring value to the previous amount may not be allowed within the terms of her policy. Because of this, it’s important that she fully considers future needs when deciding between withdrawals and loans.

When you take a loan, you’re taking cash value from your contract and reducing your net death benefit. As long as the policy remains in force, you can choose to pay back that loaned money with interest to restore your death benefit and cash value. Loans are generally income tax-free.³

Let’s say disaster strikes and you die while the cash value from your policy is still on loan. (Or, maybe you decide that you don’t want to pay it back.) Loans will reduce the amount paid to your beneficiary when you die.

The amount you can borrow from a life insurance policy is determined by the type of policy you have and its current cash value. How much you’ve paid in premiums also can impact how much is available to borrow. The consequences of borrowing also may be tied to how much you’ve paid in.

Once a life insurance policy allows borrowing, you can often borrow tax-free up to the basis in the contract. As a reminder, basis is the total of all the premiums you have paid—minus any previous withdrawals and dividends received. Anything borrowed beyond that amount will require an income tax payment. Think of this last piece as new income that you haven’t paid taxes on before.

If you withdraw all or nearly all of the money from your life insurance policy, it likely will terminate. It's important to monitor your contract and ensure your funding is sufficient if you want to keep the life insurance active.

This is when you end or surrender your contract early. You may incur a tax penalty if you take all the cash value available. You’ll be taxed on any money you receive that is greater than what you made in payments while your contract was active. You’ll have cash, but you won’t have life insurance anymore.

Thinking about canceling your life insurance policy? Read this first.

The taxability of life insurance

Life insurance contracts have unique features that can help families manage their tax liability. Get the key details you need to know in our essential guide.


Explore our life insurance taxability guide

Cash value in life insurance has three main income tax advantages: usually income-tax-free death benefits, tax-deferred cash accumulation, and usually income tax-free withdrawals and surrenders.

Death benefits are generally received income tax-free.¹ However, everyone's financial situation is different. So, you'll need to double-check what's true in your case by talking to your financial advisor and tax attorney. Generally speaking, the income-tax-free nature of death benefits is a big plus of having life insurance.

Many types of cash value life insurance come with an interest rate, dividends or investment options. That allows you to grow money inside your policy if economic winds are in your favor.

There’s always the opportunity to lose money, too. Interest rates, investment returns and dividends aren’t guaranteed. And investment returns are subject to market volatility.

But let’s say you experience the best-case scenario and your cash value grows. That growth within a life insurance policy can be tax-deferred. You usually don’t have to pay taxes on your gains until you take a withdrawal.

If you no longer need your death benefit coverage, in full or in part, you may be able to access the cash value of your contract to cover other financial needs. Although withdrawals are usually income tax-free, there are special cases where withdrawals and surrenders can generate an income tax liability. For example, a significant taxable event can occur if a contract terminates with outstanding debt. Contact your tax advisor and financial advisor for details.

When designing a strategy, you might have a goal of adding as much premium as possible to a contract, as bigger payments may lead to a larger cash value. But if your payments exceed Internal Revenue Code limits, the contract becomes a MEC.

Many people prefer to avoid MEC status, especially if they intend to access the cash value in a contract during their lifetime. However, when a life insurance contract becomes a MEC, the cash value continues to grow in the contract tax-deferred. This may be appealing if you need life insurance coverage, but do not expect to access the value while you are living and want to shelter growth on that asset from annual taxation.

There are additional pros and cons of MECs that should be considered in full.^3,4 Read more about modified endowment contracts and consult a financial advisor or tax professional before making changes to your cash contributions.

You can build up cash value faster by increasing the size of your premium payments if your policy allows it. For policies that don’t allow it, there may be other options. One of those options is using any dividends earned to purchase paid-up additions. Similar to how you can reinvest stock dividends to buy more shares, you can "reinvest" insurance dividends to increase your contract's death benefit and cash value.