Whole Life Insurance: Accruing Cash Value Over Time

Whole life insurance is a type of permanent life insurance that includes a cash value feature. This means that, in addition to providing a death benefit, the policy also accumulates cash value over time. This cash value can be accessed by the policyholder during their lifetime, typically through loans or withdrawals, and can be used for various purposes such as supplementing retirement income, paying for a child's education, or covering unexpected expenses. The cash value component of whole life insurance offers a guaranteed rate of growth and is tax-deferred, making it a potentially attractive option for individuals looking for both insurance coverage and a savings vehicle. However, it's important to note that cash value policies tend to have higher premiums than term life insurance policies due to the additional savings component.

Premium payments

Upon making a premium payment, the funds are allocated into three distinct categories. Firstly, a portion of the payment is directed towards the policy's death benefit, which is tailored to the policyholder's age, health, and other underwriting factors. Secondly, a part of the premium covers the operating costs and profits of the insurance company. Lastly, and most importantly for accruing cash value, the remaining portion of the premium payment is allocated directly to the policy's cash value.

It is important to note that the distribution of premium payments across these categories changes over time. Initially, during the early years of the policy, a larger proportion of the premium is directed towards the cash value, allowing it to grow at a faster rate. However, as the policyholder ages, the cost of insuring their life increases, leading to a higher proportion of the premium being allocated to cover this expense. Consequently, the cash value accumulation slows down as the policy matures.

Policyholders should be aware that it may take several years for the cash value to start accruing. Typically, there is a waiting period of two to five years before the cash value begins to build. During this time, the insurance company invests the premium payments in conservative-yield investments. Once the cash value starts to accumulate, it grows over the years through continued premium payments and earned interest.

The rate of return on the cash value varies depending on the type of policy. Whole life insurance policies, for example, offer a fixed rate of return, while universal life insurance policies have a variable rate dependent on how the premium payments are invested.

It is worth noting that the cash value component of whole life insurance policies provides a valuable financial tool. Policyholders can utilise the accumulated cash value for various purposes, such as paying premiums, taking out loans at lower rates, creating investment portfolios, or supplementing retirement income. However, any withdrawals or loans against the cash value will impact the overall death benefit.

Interest accumulation

The interest accumulation process usually begins after the first year of the policy, with the cash value starting to accumulate at a minimum guaranteed rate. This guaranteed rate is determined by the insurance company and is unaffected by financial markets. The cash value can also accumulate at a higher, non-guaranteed rate, which is also set by the insurer.

The interest earned on the cash value of a whole life insurance policy is dependent on the type of policy chosen. Whole life insurance policies offer a fixed rate of growth, whereas universal life insurance policies accumulate cash value based on current interest rates and investments. Variable life insurance policies are dependent on the performance of subaccounts, which operate like mutual funds, while indexed universal life insurance policies are linked to the performance of an index, such as the S&P 500.

The accumulation of interest on the cash value of a whole life insurance policy provides a living benefit for the policyholder, who can access these funds in several ways. Partial withdrawals or surrenders are usually permitted, although this may reduce the death benefit and can be subject to taxation if the withdrawal exceeds the amount paid into the cash value. Policy loans are also an option, with the policy acting as collateral, and the cash value can also be used to pay policy premiums.

The interest accumulation feature of whole life insurance policies offers a mechanism for policyholders to build a nest egg over several decades, providing a financial tool that can be utilised for a variety of purposes during the insured's lifetime.

Borrowing against the policy

Borrowing against your whole life insurance policy is a quick and easy way to get cash in hand when you need it. However, it's important to understand the process and potential risks involved. Here are some key points to consider:

How Borrowing Works

When you borrow against your whole life insurance policy, you are taking a loan from the insurer, with the cash value of your policy serving as collateral. This means that you are essentially borrowing from yourself, and there is no need for a lengthy approval process or credit check. The loan amount can be up to 90% of the policy's cash value, and the interest rates are typically lower than those of a bank loan or credit card. However, interest will accrue on the loan balance, and it is important to make regular payments to avoid the loan amount growing larger than the policy's cash value, which could cause the policy to lapse.

Impact on Death Benefit

It's important to understand that borrowing against your policy will reduce the death benefit that your beneficiaries will receive. The loan amount, plus any accrued interest, will be subtracted from the death benefit. Therefore, it is crucial to consider the long-term impact on your beneficiaries before taking out a loan.

Tax Implications

In most cases, loans against the cash value of a whole life insurance policy are tax-free. However, if the policy lapses or is surrendered with an outstanding loan, the amount of the loan that exceeds the premiums paid may be considered taxable income. It is important to understand these potential tax consequences and plan accordingly.

Repayment Considerations

While there is no fixed monthly payment required for policy loans, it is wise to have a repayment plan in place to avoid accumulating too much interest. Regularly reviewing your policy's cash value and loan balance can help you stay on track. Additionally, consider how the loan will impact your long-term financial goals and whether you can afford to repay it.

Advantages and Disadvantages

Borrowing against your whole life insurance policy offers several advantages, including quick access to cash, no impact on your credit score, and flexible repayment terms. However, there are also disadvantages to consider. You may have to wait for the cash value to build up sufficiently, and there is a risk of losing your coverage if you don't make payments. Additionally, whole and universal life insurance policies, which are the only types that allow borrowing, are more expensive than term life insurance and may provide more coverage than necessary.

Withdrawing from the policy

Withdrawing from a whole life insurance policy is a serious decision that should not be taken lightly. It is important to carefully consider the potential consequences and consult relevant experts before taking action. Here are four options for withdrawing from a whole life insurance policy:

Surrender the policy

You can cancel your life insurance policy and receive the "surrender value", which is the cash value minus any fees. This option should be carefully considered as it will result in the loss of life insurance coverage, and your beneficiaries will not receive a death benefit when you pass away. There may also be penalties for cashing out early, known as surrender charges, and income tax may be owed if the payout exceeds the premiums paid.

Partial withdrawal

It is possible to withdraw part of the cash value in a permanent life policy without cancelling the coverage. This will result in a reduced payout for your beneficiaries in the event of your death. Withdrawals are generally not subject to income tax if they do not exceed the amount of premiums paid into the policy. However, withdrawals may have unexpected consequences, such as a reduction in the death benefit that is greater than the amount withdrawn.

Borrowing against the policy

Many policies allow you to borrow against the cash value, using it as collateral. Borrowing against life insurance can be easier than getting a traditional loan as there is no credit check and a flexible repayment timetable. Interest rates on life insurance loans are typically lower than those for personal loans or home equity loans. However, the borrowed amount will generally reduce the death benefit, and any unpaid loan balance accruing interest can reduce the cash value, potentially causing the policy to lapse.

Using cash value to pay premiums

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

Surrendering the policy

Surrendering a whole life insurance policy means cancelling the policy. Instead of your beneficiaries receiving the death benefit, you as the policyholder will receive the cash value your whole life insurance policy has built up over time. This can be an appealing prospect, especially if you no longer need the coverage of the policy to make sure outstanding debts like a mortgage or other loans are paid off. However, this decision can also cause you to lose out on a significant amount of return on your investment in the policy.

There are two main caveats to surrendering a policy. Firstly, if your policy isn’t very old, you may incur surrender fees which will lessen the amount of cash you receive. Secondly, the gain on your policy—however much it may be—will be taxed as income. Death benefits are tax-exempt, but the cash you receive from surrendering is taxable. Consult your tax professional before making any decisions.

If you surrender the policy during the early years of ownership, when the value is relatively low, the company will likely charge surrender fees, reducing your cash value. These charges vary depending on how long you've had the policy and, often, on the amount being surrendered. Some policies can levy surrender charges for many years after the policy is issued.

In addition, when you surrender your policy for cash, the gain on the policy is subject to income tax. Additional taxes could be incurred if you have an outstanding loan balance against the policy.

Although surrendering the policy can get you the cash you need, you're relinquishing the right to the death-benefit protection afforded by the insurance. If you want to replace the lost death benefit later, getting the same coverage might be more complicated or more expensive.

If you have the means, consider other options before using your life insurance policy for cash, such as borrowing against your 401(k) plan or taking out a home equity loan.

If you surrender a term life insurance policy, you can cancel it at any time, but since there is no cash value component included in term life, there’s no money to get back.

Frequently asked questions