When you shop for life insurance, you've got two basic options: term or permanent. Term life insurance covers you for a specific period of time, usually one, 10 or 20 years.
Permanent life insurance, such as whole life, universal life, or variable life, covers you for the remainder of your life.
Permanent life insurance also offers a feature that's commonly viewed as a strong selling point: the ability to grow cash value in your policy. In addition to lifelong insurance protection, a portion of your premium payments goes toward a separate cash account that grows over time.
The cash value element is one reason permanent life insurance costs more than term insurance. When is building up cash value worth the extra money you'll pay for the permanent life policy?
Consider your needs
Rob Roy, owner of Sugar Creek Financial Group in Stafford, Texas says in many cases, your best bet is to have a mix of cash value and term policies. “To get the most coverage for the least amount of money, especially if you have short term financial obligations such as children in college, I would certainly recommend term insurance. But if you’re looking for a policy that will last and create an estate, ensuring you have a policy in place to protect your loved ones, a cash value policy is the right option.”
Roy says when considering a cash value policy, consider several factors. “I would certainly look at the company you’re considering, making sure it’s one of the top rated companies. Look at the internal costs of the policies and have them broken down, so you can make sure there are no hidden fees, Roy says. “Also determine whether the company you are considering is a mutual or stock company, and how it pays over and above its guarantees.”
How cash value builds
Let's say you're young and you own a $100,000 universal life insurance policy, and your premium payments are $800 a year. Your insurance company will take about $150 to pay a "mortality expense," which is the main cost of providing insurance, and another $50 to cover other costs and processing fees. After that, the company puts $600 toward your cash value.
That sounds like a great deal, but don’t expect it to last. As you grow older, the cost of insuring you goes up because your chance of dying goes up each year. Since more and more dollars go toward the cost of insuring you as you age, less money is going toward your cash value. As you age, the mortality expense grows faster than the cash value.
Think of cash value as a racehorse that has incredible speed and power out of the gate, but then tires out and trots to the finish line. Likewise, it's common for cash value to accumulate quickly in the early years, but grow much more slowly later. A company's mortality expense generally doubles every 10 years. So, if the insurer takes $150 out of your premium for mortality expenses when you're 25, it may take out $300 at age 35, $600 at age 45, and so on. That means less money is going to your cash value.
Keep in mind that although your mortality expense has gone up, your premiums will stay level because the insurance company has already taken your increasing mortality into consideration. Premiums may go up if you own a universal life policy, where you have flexibility in your premium payments. If you pay too little premium in the early years, your premium bills may skyrocket in the later years to make up the difference.
The cash value in your policy grows each year with interest. A traditional whole or universal life insurance policy can earn around 6 percent per year, and most companies guarantee that you will earn at least 4 percent. You could possibly earn more in a variable life insurance contract, where your money is tied to the performance of stocks, bonds, or mutual funds. You also run the risk of losing money in your cash value if your underlying investments perform poorly.
When you die, generally your beneficiaries do not get the death benefit plus the cash value you have built up in the policy. For universal and variable universal life insurance policies, you can choose to have your cash value added to the death benefit, but you must specifically select this option (and the higher premiums that go along with it) for your beneficiaries to receive the cash value.
Tapping into your money
You can access the cash value in your life insurance policy, but it will cost you. Cash value is not like a savings account where you can withdraw funds automatically and not have to pay fees or penalties. In fact, some states will not allow insurance companies to use the words "investment," "investment plan," or "retirement plan" when marketing insurance products because those words may deceive customers.
The most common way people access their cash value is by taking out a loan against their policy and paying it back with interest, usually at 7 to 8 percent. You're not obligated to pay it back, but the money you owe, plus interest, will be deducted from your death benefit when you die. So if you don't pay for it, your beneficiaries will lose out.
You can also make a partial withdrawal of your cash value, but your death benefit will be reduced. Exactly how much varies by policy, but in most cases, it would be reduced on a dollar-for-dollar basis. For example, if you had a $100,000 death benefit with $20,000 worth of cash value built up, and you withdrew $10,000 of cash value, your death benefit would be $90,000.
In some cases, partially withdrawing your cash value could decimate your death benefit. For some traditional whole life policies, the death benefit could be reduced by at least double of what you withdraw.
The taxman cometh
Your cash value is tax-deferred, meaning you will not pay taxes on it unless you withdraw funds. 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 withdrew 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 10 to 12 years on an average whole life insurance policy or 15 to 18 years on universal life, depending on how much premium you've paid in. The slow accumulation of wealth makes cash value a less desirable choice for the short term.
A loan 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.
Who needs cash value?
If you have a high income and feel you need insurance for the rest of your life, then whole life insurance might be the right choice for you. While you can't access the money like you could with a savings account, cash value is a good feature to have if you need the insurance for life.
Many older people with large estates prefer whole life because they can use their cash value to pay for premiums when they are older and on a fixed income. Although withdrawing cash value to pay premiums will reduce the death benefit, they want to keep the life insurance in force so the death benefit can be used by beneficiaries to pay estate taxes when they die.
But if you're concerned only with pure insurance protection, and don't have the money for high premiums, term insurance may be a better choice for you. Some experts argue the money you save in premiums by buying term life instead of whole life can be invested in stocks, bonds, and mutual funds. You'd lose the tax deferred feature, but you may make more money in the long run by investing it yourself, depending on the market.
Consider the costs
According to LIMRA International, a financial services trade association, the premiums for a universal or whole life insurance policy could be as much as nine times higher every year than a term life insurance policy with the same death benefit.
For example, a $250,000 term life insurance policy would have cost an average of $560 per year. The same death benefit for a variable universal life insurance policy, bought at the same time, would average $3,988 every year, according to LIMRA.
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