Life Insurance: Gaining Value Through Protection

Life insurance is a valuable financial tool that provides peace of mind and financial security for individuals and their loved ones. While the primary purpose of life insurance is to offer protection in the event of the policyholder's death, certain types of life insurance, known as cash value or permanent life insurance, also offer additional benefits while the policyholder is alive. This type of life insurance includes a savings component that accumulates cash value over time, providing a source of funds that can be accessed for various purposes. This feature makes life insurance an even more attractive and versatile financial product.

Cash value life insurance explained

Cash value life insurance, also known as permanent life insurance, includes a cash component in addition to a death benefit. This cash component can be used for several purposes, including borrowing or withdrawing cash from it, or using it to pay policy premiums.

Cash value life insurance provides coverage for the policyholder's entire life. It is more expensive than term life insurance because of the cash value element. When you make a premium payment, it is divided into three parts: the policy's cash value, the insurer's cost of providing the death benefit, and life insurance company fees and charges. The cash value component of the premium payment grows based on a fixed amount, investment gains, or a combination of the two. This cash value can be used to cover premium payments if it builds up sufficiently.

Types of Cash Value Life Insurance

There are several types of cash value life insurance policies to choose from, each with its own unique features and risks. Here are some of the most common types:

• Whole Life Insurance: Offers fixed monthly premiums, a fixed rate of growth for cash value, and a guaranteed death benefit amount. It is typically more expensive due to these guarantees.
• Guaranteed Issue Life Insurance: A type of whole life insurance that does not require a medical exam or health questions. The coverage amounts are generally small, resulting in a smaller potential cash value. It usually has a graded death benefit, where the full payout is not provided if the insured person passes away within two to three years of purchasing the policy, unless the death was due to an accident.
• Guaranteed Universal Life Insurance: This type of universal life insurance has fixed premium and death benefit amounts, with minimal cash value accumulation.
• Indexed Universal Life Insurance: Connects cash value growth to gains and losses in an index like the S&P 500. Premium and death benefit amounts can be adjusted within certain parameters.
• Variable Universal Life Insurance: The cash value growth is tied to sub-accounts containing investments of your choice, usually bonds and mutual funds. There is a risk of losing money in the cash value if the chosen investments do not perform well. Premium and death benefit amounts can be adjusted within set limits.

Benefits and Drawbacks of Cash Value Life Insurance

Cash value life insurance offers several advantages, such as providing a death benefit for beneficiaries, the potential for dividends, and tax advantages. However, it also has some drawbacks, including higher costs compared to term life insurance, the time it takes to build cash value, and the possibility of policy lapse if too much money is borrowed.

Whole life insurance cash value charts

Whole life insurance is a type of permanent life insurance that provides coverage for the entire lifetime of the policyholder. It guarantees a death benefit to the beneficiaries upon the policyholder's death and includes a savings component known as the cash value. This cash value grows over time at a guaranteed rate set by the insurance company and can be used by the policyholder for various financial needs, such as loans or withdrawals, while they are still alive.

Whole Life Cash Value Chart #1

This example assumes a $12,000 yearly premium. In the initial years, the funds go entirely towards the cost of insurance and the insurer's operating costs. Over time, the cash value account grows, especially given the tax-deferred feature that takes annual gains taxes out of the equation. Eventually, the insured can stop making premium payments altogether and instead fund the policy using money from the cash value.

Whole Life Cash Value Chart #2

In this example, the policy is structured so that a portion of the premium payment goes equally to the base and to paid-up additions. This design provides more cash value, with a lower initial death benefit that will grow over time as the cash value in the policy increases.

Whole Life Cash Value Chart #3

This example is structured for maximum early cash value growth, with the base policy, paid-up additions, and a term rider. The addition of the term rider allows for more cash to be put into the policy in the early years.

It's important to note that not all whole life insurance policies are the same. Some policies may offer higher returns, while others may have lower risks associated with cash value accumulation. It's crucial to understand how cash value accumulation and risk correlate to choose a policy that fits your needs and risk tolerance.

How cash value is calculated

There is no simple answer for how to calculate the cash value of a life insurance policy. This is because cash value is accumulated differently for different types of policies.

In general, the cash surrender value of a life insurance policy is determined by the amount of premiums paid, the length of time the policy has been in force, and the size of the death benefit. The exact calculation will depend on the insurer and the type of policy.

For example, whole life insurance policies have guaranteed cash value accounts that grow based on the insurance company's formula. Universal life insurance, on the other hand, uses market interest rates to grow cash value, and variable universal life insurance is linked to the performance of an index.

When you pay a premium on a cash value life insurance policy, the payment is typically split into three categories: a portion goes towards the policy's death benefit, another portion covers the insurer's operating costs and profits, and the rest contributes to the policy's cash value.

Over time, the percentage of your premium that goes towards cash value decreases, while the amount allocated to insurance increases as you age and the cost of insuring your life gets more expensive.

It's important to note that any accumulated cash value will typically be returned to the insurance company upon your death, and your beneficiaries will only receive the death benefit.

The tax advantages of cash value life insurance

Cash value life insurance has several tax advantages. Firstly, the death benefit paid to beneficiaries is generally not taxed. This means that your loved ones will receive the full sum without a tax burden. Secondly, the cash value component of the policy grows tax-deferred. This means that the money in the cash value account is not taxed while it is growing, allowing it to accumulate faster. You can also access the cash value through withdrawals or loans without immediate tax consequences, as long as they are structured properly. However, it is important to note that if you withdraw more than the total amount of premiums paid into the policy, you may have to pay taxes on the excess amount.

Another tax advantage of cash value life insurance is the potential to receive dividends from the insurance company. These dividends are generally not taxable and can help increase the cash value of the policy. Additionally, if you borrow money against the cash value of your policy, the loan is typically not treated as taxable income. However, it is important to note that the loan will have interest charged by the insurance company, and if the loan is not paid back, it will reduce the amount of the life insurance payout to your beneficiaries.

Furthermore, cash value life insurance can provide tax advantages in estate planning. The life insurance payout is usually exempt from probate processes, which can take several months. This means that your beneficiaries will receive the money faster, often within a few weeks. Additionally, the death benefit is typically income-tax-free, providing a significant financial benefit to your loved ones.

Overall, cash value life insurance offers several tax advantages, including tax-free death benefits, tax-deferred growth of cash value, tax-free withdrawals and loans, and the potential for tax-free dividends. These advantages make cash value life insurance an attractive option for individuals looking for both insurance coverage and a way to build tax-favored savings.

How to withdraw cash value from life insurance

There are several ways to withdraw the cash value from a life insurance policy. However, it's important to note that the options available, as well as their respective pros and cons, can vary depending on the type of policy and the insurance company. Here are some common methods:

Surrendering the Policy

Surrendering or cancelling the policy is an option, but it should be considered a last resort as it will result in the loss of life insurance coverage. By surrendering the policy, you can receive the cash value minus any surrender fees or charges. These fees can be significant, especially for newer policies. Additionally, you may have to pay taxes on the gains earned on the cash value portion.

Withdrawing Cash

Withdrawing cash from a life insurance policy is often allowed, and the withdrawn amount is typically not subject to income taxes as long as it doesn't exceed the total amount paid into the policy. However, this option usually leads to a reduction in the death benefit, and there may be potential tax consequences depending on the timing and amount of the withdrawal.

Taking a Loan

You can borrow money through your life insurance policy, using the cash value as collateral. The amount borrowable varies and is generally provided at a lower interest rate than personal loans. There is no loan application or credit check required, and the credit rating does not impact the interest rate. Repaying the loan is optional, but if left unpaid, the outstanding loan balance will typically be deducted from the death benefit.

Using Cash Value to Pay Premiums

The cash value in a life insurance policy can often be used to pay part or all of the policy premiums, making it easier to maintain coverage. This is a popular option for older policyholders who want to use their retirement income for living expenses while still retaining life insurance.

It is recommended to consult a financial advisor or tax professional before making any decisions regarding your life insurance policy, as the specific terms, conditions, and tax implications can vary based on individual circumstances.

Frequently asked questions