What is Cash Value Life Insurance?
When you pay premiums on a cash value life insurance policy, part of your money builds cash value- similar to a savings account inside the policy. Over time, this cash value grows. During your lifetime, you can access it through withdrawals, policy loans, or by surrendering the policy.
Many families also use cash value life insurance as part of broader financial planning for seniors to help cover education costs, retirement needs, or unexpected expenses.
How can you access the cash value in your policy?
The cash value in your policy can be accessed in one of three ways: withdrawals, policy loans, or surrender of the policy.
Cash Value Life Insurance Withdrawals
When the time comes to pay your child’s college tuition, one option is to withdraw some or all of the cash value of your policy. The amount you can withdraw is generally limited to a percentage of the cash value, and varies by policy and company. Most insurance companies charge a processing fee.
The main advantage of cash value withdrawals is such withdrawals up to your policy basis, are not considered taxable income. Taxation is based on the FIFO accounting method (first in, first out). In other words, the first dollars you take out are considered a return of the premiums you paid.
Example(s): Suppose you own a life insurance policy with a cash value of $15,000. Your basis in the policy equals $12,500. You plan to withdraw $7,000 now to pay your son’s tuition. You won’t pay tax on this withdrawal amount because it is considered a return of your policy basis.
Keep in mind:
Caution: Withdrawals are treated as taxable to the extent they exceed your basis in the policy.
Caution: Cash value withdrawals that occur in the first 15 years of the policy and are accompanied by a reduction in the face amount of the policy may be subject to taxation according to the LIFO (last-in, first-out) method. In this case, the withdrawals are treated as coming first from interest.
Caution: There are special taxation rules for policies that are classified as modified endowment contract (MEC) policies.
The main disadvantage of cash value withdrawals is such withdrawals will lower your death benefit. The sum of cash paid by the insurance company at your death).
Cash Value Life Insurance Policy loans
Cash values can be borrowed against using a policy loan. Policy loans are allowed under the terms of your insurance contract. In other words, you won’t have to undergo a credit check or bank loan approval process for a policy loan. When you take out a policy loan, the check you receive comes out of the general funds of the insurance company, not your cash value. Your policy cash value serves as collateral for the loan.
The interest rate on a policy loan is known in advance and may be lower than that on a bank loan. Some policies allow you to borrow at an interest rate only slightly higher than the rate being credited to cash values. With other policies, the interest rate on the loan equals the rate credited to cash values, for a zero net cost loan
Note: that interest accrues on any unpaid loan balance. If you choose not to repay the loan, the accruing interest may erode your cash values and result in the lapse of the policy. Unfortunately, the interest you pay on a policy loan for education expenses is not tax deductible.
Keep in mind:
Caution: If you die with an outstanding policy loan against your account, your death benefit is reduced by the amount of the outstanding loan balance.
The main benefit of policy loans is that the loan proceeds are generally not subject to income tax. This is true even if the loan is larger than the amount of premiums you have paid into the policy, except in the case of a policy treated as a modified endowment contract (MEC).
Example(s): You own a life insurance policy (which is not a MEC) with a cash value of $20,000. Your basis in the policy is $17,000. You decide to take a policy loan to pay your daughter’s college tuition. Under the terms of your policy, you are allowed to take a loan for an amount up to 90 percent of the policy cash value, in this case $18,000 ($20,000 x.90). If you take the $18,000 loan, you are not subject to tax on the amount of the loan, even though the loan is larger than your basis.
Cash Value Life Insurance Withdrawals and policy loans combined
Cash value withdrawals and policy loans are not mutually exclusive. You can use a combination of withdrawals and loans to maximize the tax-free cash withdrawal benefits. For example, you might choose to make cash value withdrawals up to the amount of your policy basis and then take a policy loan.
Example(s): You have a daughter you are putting through college and you want to access the cash value in your life insurance policy. You might make a tax-free withdrawal of the cash value from the policy in an amount equivalent to the amount of premiums you have paid into the policy. After you withdraw up to your basis in the policy, you might then take out a policy loan. In insurance terms, this is referred to as a “surrender to basis and switch to a loan.
Surrender
In addition to withdrawals and policy loans, you can surrender (cancel) your policy. The final cash value can then be put toward private school or college tuition. However, surrender fees will likely be charged if you cancel the policy. These charges will vary depending on how early or late in the life of the policy the cancellation occurs. For example, some policies carry a 15- to 20-year surrender schedule. In addition, when you surrender your policy for cash, the gain on the policy is subject to federal income tax (your gain is the difference between the net cash value and your policy basis).
Caution: If you surrender your policy while there is an outstanding policy loan, there could be additional tax consequences.
Can your child access the cash value in the policy?
Yes. If you own a cash-value life insurance policy, you can gift the policy to your child. Before you transfer ownership, consider withdrawing cash value up to your cost basis. This strategy can help you reduce taxes.
Example
Your son attends college, and you plan to gift him your cash-value life insurance policy. First, you withdraw an amount equal to the premiums you paid. This withdrawal is tax-free. Next, you gift the policy to your son.
Once he becomes the owner, he can access the remaining cash value. He may take withdrawals or borrow against the policy. His withdrawals will follow his income tax rate, which is often lower than yours.
Important Considerations
You may need to continue paying premiums through additional gifts to keep the policy active. Otherwise, the policy could lapse.Also, keep in mind that gifting a life insurance policy or paying premiums on someone else’s behalf may trigger gift tax consequences. Always review your strategy with a financial or tax professional.Many families coordinate cash value policies with long-term care planning to protect assets while preparing for future health needs.
FAQs:
1. What is cash value life insurance?
Cash value life insurance is a type of permanent life insurance that builds savings over time. Part of each premium goes toward a cash value account inside the policy. This value grows and can be accessed during your lifetime through withdrawals, loans, or by surrendering the policy.
2. How can I use the cash value in my policy?
You generally have three options:
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Withdrawals – Take money directly from the cash value
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Policy loans – Borrow against your policy using the cash value as collateral
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Surrender – Cancel the policy and receive the remaining cash value (minus fees)
Each method has different tax and financial implications.
3. Are cash value withdrawals taxable?
Withdrawals are typically tax-free up to the amount of premiums you’ve paid (your policy basis). Any amount taken above that may be taxed as income.
However, special rules apply if:
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The policy is a Modified Endowment Contract (MEC)
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Withdrawals occur early in the policy and reduce the death benefit
In these cases, taxes may apply sooner.
4. Do withdrawals affect my death benefit?
Yes. Any money withdrawn permanently reduces your policy’s death benefit, meaning your beneficiaries may receive less when you pass away.
5. What is a policy loan, and how does it work?
A policy loan allows you to borrow money using your cash value as security. You don’t need credit approval, and loan interest rates are usually competitive.
Key points:
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Loan proceeds are generally not taxable
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Interest accumulates on unpaid balances
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If unpaid, loans can reduce your cash value or cause the policy to lapse
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If you die with an outstanding loan, the balance is deducted from the death benefit
6. Can I combine withdrawals and policy loans?
Yes. Many policyholders withdraw cash up to their policy basis first (tax-free), then take a policy loan for additional funds. This strategy is sometimes called “surrender to basis and switch to a loan.”
7. What happens if I surrender my policy?
Surrendering means canceling the policy and receiving the remaining cash value after surrender charges. Any gain above your policy basis is subject to income tax.
If there’s an outstanding loan at surrender, additional taxes may apply.
8. Can my child access the policy’s cash value?
Yes. You can transfer ownership of the policy to your child. Before doing so, many parents withdraw cash up to their basis to reduce taxes.
Once your child owns the policy, they can access the remaining cash value. Any withdrawals will be taxed at your child’s income tax rate, which may be lower.
