How does the cash value of life insurance work?

Life insurance is a valuable tool for ensuring your loved ones will be taken care of financially after you die. It can also be useful for building and transferring wealth.

Some types of life insurance have what’s known as a “cash value” – money that’s yours to keep and use even before you die. Keep reading to learn more about the cash value of life insurance and how it works.  

What is the cash value of life insurance?

There are two types of life insurance: term life insurance, which covers you for a specified length of time; and permanent life insurance, which covers you for your entire life.

Cash value is a component of many permanent life insurance policies. As you pay the premiums, you build up a “cash value” component that you are free to withdraw or use as collateral for a loan. When you die, any amount you’ve withdrawn is deducted from the death benefit.

How does a life insurance policy build cash value?

The way your life insurance policy’s cash value is calculated differs among insurers and plans – let’s take a look at three common options. 

Type of insurance	How cash value works
Whole life insurance	The cash value grows based on a formula or set schedule determined by your insurer. It is guaranteed.
Universal life insurance	The cash value grows based on investments and current interest rates.
Variable life insurance	The cash value grows based on the performance of subaccount.

As a simple example, let’s say you take out a non-participating whole life insurance policy for $150,000 when you’re 40 years old. This particular policy includes a guaranteed cash value that begins accumulating in the third year and grows evenly until it reaches 50% of the death benefit when you reach age 65.

In this example, your cash value will grow by $3,125 every year, starting the year you turn 42. In the year you turn 65, the cash value will reach $75,000.

Age	Cash value	Death benefit
40	$0	$150,000
41	$0	$150,000
42	$3,125	$150,000
43	$6,250	$150,000
44	$9,375	$150,000
45	$12,500	$150,000
46	$15,625	$150,000
47	$18,750	$150,000
48	$21,875	$150,000
49	$25,000	$150,000
50	$28,125	$150,000
51	$31,250	$150,000
52	$34,375	$150,000
53	$37,500	$150,000
54	$40,625	$150,000
55	$43,750	$150,000
56	$46,875	$150,000
57	$50,000	$150,000
58	$53,125	$150,000
59	$56,250	$150,000
60	$59,375	$150,000
61	$62,500	$150,000
62	$65,625	$150,000
63	$68,750	$150,000
64	$71,875	$150,000
65	$75,000	$150,000

This example policy pays $150,000 no matter when you die but doesn’t accumulate its full cash value until you turn 65.

How can I use the cash value of my life insurance policy?

If your life insurance policy has cash value, you can access it in a number of ways:

• Withdraw cash. You have the option to withdraw cash from your life insurance policy and use it however you see fit. Note that there may be tax consequences for making a cash withdrawal.
  
  
• Use as collateral for a loan. When you get a mortgage, the home is used as collateral to secure the loan. Similarly, you can use the cash value of your life insurance policy to secure a loan. This strategy may help reduce the immediate tax consequences of accessing your cash value.
  
  
• Surrender for cash value. You may also have the option to “surrender” your life insurance policy and take the cash value. By doing this, you end your responsibility to make payments but also give up your death benefit. Surrendering a life insurance policy has tax implications for you and your estate, so it’s best to consult with a financial advisor before making a decision.
  
  
• Use cash value to pay premiums. As you get older, you may prefer to let your policy pay its own premiums from its cash value rather than continue to pay them yourself. Your policy will likely include an option to do this automatically, known as “paid up” insurance.
  
  
• Purchase more insurance. If your cash value is derived from investments, you may be able to use it to buy more insurance and increase your death benefit which could reduce the tax burden on your beneficiary.

What are the downsides of withdrawing cash value from my life insurance policy?

Withdrawing cash from your life insurance policy has consequences. Consider the following before dipping in:

• You may have to pay tax on the life insurance cash value withdrawal. When you withdraw cash from your policy or borrow against its cash value, you may have to pay income tax on the money you take out. The tax burden may be substantially lower if you leave the cash value to be inherited.
  
  
• Fees may eat into your savings. In addition to taxes, your insurance company may charge you fees to access your cash value, which can undo your hard work.
  
  
• Withdrawals are deducted from the death benefit. Every dollar you take out from your life insurance policy, whether borrowed or taken in cash, is deducted from the amount paid to your beneficiary when you die.

Check with your insurance broker or financial advisor before withdrawing cash from your life insurance policy to make sure you’re using the best strategy for your current needs as well as your estate.

How does participating life insurance work?

Some life insurance plans are labelled as “participating” – these policies essentially offer an extra form of cash value through dividends. Your insurer allocates your regular premiums toward a professionally managed account which then has the potential to generate dividends. Dividends can then be taken out as cash for your needs, supplemented towards your cash value, or used to pay your policy premiums. You may also be able to use the money to increase your policy death benefit, leaving your loved ones with more coverage after your passing. 

The bottom line

Getting a life insurance policy with a cash value component can be a useful way to balance estate planning with your own future. Compare life insurance quotes online to find the right policy for you.

Also read

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Can I have multiple life insurance policies?