Cash value life insurance: What’s it worth to you?
By Insure.com | Last updated: Jan. 1, 2015
When you shop for life insurance, you’ve got two basic options: term or permanent life insurance.
Term life insurance covers you for a specific period of time, usually 10, 15, 20 or 30 years. If you live past your policy’s term, there is no payout to your beneficiaries.
Permanent life insurance, such as whole life, universal life or variable universal life insurance, covers you for the duration of your lifetime. It also offers a feature that’s commonly viewed as a strong selling point: cash value. In addition to lifelong insurance coverage, a portion of your premium payments goes toward a cash value account that grows tax-deferred over time.
When is building up cash value worth the extra money you’ll pay for the permanent life insurance policy?
Cash value: Worth the extra cost?
The cash value account is one reason whole life insurance premiums are higher than premiums for term insurance. Cash value grows slowly at first and generally picks up earnings speed after several years. The cash value in your policy grows each year with interest, tax-deferred. (Some policies grow cash value at a more steady rate; your insurance agent will show you illustrations of possible outcomes.)
Once you have accumulated enough cash value, you can opt to use it to cover your premium payments. This is known as being “paid up.” If you decide to withdraw some cash value, you may have to resume premium payments to keep the life insurance policy in force.
Another common way people access their cash value is by taking out a loan against their policy and paying it back with interest at a rate that’s generally lower than a bank loan. You’re not obligated to pay it back, but the money you owe, plus interest, will be deducted from the death benefit when you die. So if you don’t pay it back, your beneficiaries will lose out.
You can also make a full or partial withdrawal of your cash value. Depending on your policy and level of cash value, a withdrawal might reduce your death benefit. Exactly how much varies by policy, but in the case of universal life insurance your death benefit would be reduced on a dollar-for-dollar basis. For example, if you had a $100,000 death benefit with a $20,000 cash value and you withdrew $10,000, your resulting death benefit would be $90,000.
In some cases, partially withdrawing your cash value could greatly reduce your death benefit. For some traditional whole life insurance policies, the death benefit could be reduced by more than the amount you withdraw.
Cash value at a glance
Let’s take a look at possible scenarios of building cash value in a traditional whole life insurance policy. (The below examples are from New York Life Insurance Co.) Remember, illustrations will vary greatly depending on the insurer, the policy face amount, the policy type and your rating classification (preferred plus, preferred, standard, etc.).
Below are illustrations of how much cash value a 35-year-old nonsmoking male with a preferred-rate $100,000 whole life insurance policy could build up over his lifetime. Policy values and benefits shown are based on a dividend scale that is not guaranteed and could be more or less than what’s shown.
The first set shows what could happen to the cash value and death benefit if he taps his cash value to pay premiums. The second set shows what could happen if he pays his premiums himself every year.
Example 1: Using cash value to offset premium payments
Source: New York Life Insurance Co.
You may be looking at this example and adding up cash value plus death benefit, but remember: With ordinary whole life insurance policies like this one, your beneficiaries do not receive the cash value when you die; they receive only the death benefit.
There are other options. New York Life and other insurers also offer universal life insurance policies that pay out the death benefit plus cash value or the death benefit plus return of premium upon your death.
Buy term and invest the rest?
You may have heard the advice to “buy term and invest the rest” rather than pay the extra premiums for the “forced savings” of a cash value policy. There are good reasons for choosing either term or permanent life insurance, depending on your financial goals. And if you’re investigating term life vs. perm, it’s helpful to be able to compare as directly as possible the costs and benefits of a term policy to a cash value policy of the same face value.
Below is a look at buying a New York Life whole life insurance policy compared to buying term life insurance in the same face amount and investing the premium difference in a “side fund” such as a bank or mutual fund. This comparison comes courtesy of James Hunt, an actuary for the Consumer Federation of America (CFA) and former insurance commissioner of Vermont. His analysis estimates the “real” interest rate earned on savings within a cash value policy.
Cash value policy vs. buying term and investing the difference every year
Source: James Hunt, Consumer Federation of America
Due to space limitations, the full 12-column analysis cannot be displayed.
In this comparison, Hunt shows that if you buy a comparable term life insurance policy you need to earn 4.6 percent in your investment vehicle in order for your side fund to equal this whole life’s cash value after 20 years. If your term life insurance side fund is invested in a bank CD or bond fund, you may not be able to net 4.6 percent after taxes.
Also important to note is the fluctuating rate of return on cash value in this particular whole life insurance policy. Your first year’s premium disappears into fees and expenses without a penny into your cash value account. Only at year 4 does the cash value rate of return go positive. That means if you drop this policy within the first few years, you’ve made a terrible investment.
And according to LIMRA International, 12.7 percent of whole life insurance policyholders will lapse their policies in the first year, 8.1 percent will lapse in the second year and another 5.5 percent will lapse in the third year.
Whole life policy average rate of return
This estimate applies only to the New York Life policy example above.
Source: James Hunt, Consumer Federation of America
The chart at the right summarizes the estimated average rate of return if you kept this particular life insurance policy 5, 10, 15 or 20 years. Even if you held this policy for 10 years, your estimated cash value average rate of return works out to only 2 percent because you’re still making up ground for those expensive first few years. You should be prepared to hold a whole life insurance policy for the long haul in order to make a potentially good investment.
Remember, this is one example of just one better-than-average whole life insurance policy and you may receive illustrations that look better or worse. Hunt’s rate of return analysis is offered through the CFA at EvaluateLifeInsurance.org .
According to the Society of Actuaries (SOA), premiums for whole life insurance can be 5 to 10 times higher than the same amount of term life insurance, depending on the kind of level term being compared. For example, if you’re comparing the premiums of 30-year level term it will be a smaller multiple, while premiums on a 10-year term policy could be a larger multiple.
Your cash value grows tax-deferred. Cash value is only taxable when it’s worth more than what you have paid into the policy. For example, if you’ve paid $20,000 in premiums, have $25,000 in cash value and withdraw $23,000, $3,000 is taxable. If you withdraw less than what you have paid into the policy, you are not going to be hit with taxes.
Having your cash value exceed your premium payments isn’t rare, but it takes a long time. It can take 12 to 15 years on an average whole life insurance policy or 15 to 20 years on universal life insurance, depending on how much premium you’ve paid in, according to the SOA. The slow accumulation of wealth makes cash value a less desirable choice for the short term.
A loan you take against your cash value could be taxed if you surrender or lapse the policy before you finish paying back the loan. The taxable portion is the difference between the loan amount and the total amount of premiums you have paid into the policy.
Ultimately, your buying decision depends on your financial goals. If you need life insurance for a finite number of years (for example, until your children graduate from college), term life insurance offers pure insurance protection. But if you’re looking to create an estate, or ensure that your beneficiaries will receive a benefit no matter when you die, whole life insurance fills that need.
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