Cash value, also known as equity, is a living benefit of a permanent life insurance policy with a savings account component. Cash value provides a guaranteed rate of return on the accumulating savings account balance. Therefore, the balance grows through the compounding interest method instead of the simple interest method. The balance is accumulating because as you pay the premium of your policy, a portion of the premium goes into the savings account.
On the plus side, a life insurance policy with a mutual insurance company will pay annual dividends, although not guaranteed. These dividends may be used to increase the cash value balance or to purchase paid-up additions. Dividends are a return of profit from the insurance company to its policyowners.
Cash value also acts as supplemental income to the policyowner via cash and loan. Cash and loan are two sources of personal funding, and these sources are funded by a portion of the premium.
The cash source can be used to pay the premium or be withdrawn tax-free for personal spending. The downside to paying the premium with cash value is that it depletes the cash value balance on a dollar-for-dollar basis. If there is no cash value left to fund the next due premium, and the policyowner misses the payment date with the grace period, the life insurance policy will lapse. The downside to withdrawing cash is that the death benefit will be reduced by more than what was withdrawn due to withdrawal penalties and fees. Again, once the cash value depletes, there is a greater risk the life insurance policy will lapse.
The loan source can be used to pay for small to large present expenses. The downside to a policyowner taking out a loan is that the death benefit is used as collateral, so if the loan is not paid back before the insured’s death, the death benefit will be reduced by the principal balance of the loan. The interest due would be deducted from the cash value balance. Therefore, the designated beneficiary will not receive the nominal face value of the life insurance policy.
Contributions of cash value are tax-deferred. Distributions, or draws, of cash value are taxed at the personal tax rate of the policyowner. Some insurance policies have restrictions on cash value deposits and withdrawals while some insurance policies allow unlimited transactions. Restrictions include a limit on the number of contributions and distributions per year as well as a limit on the total amount of contributions and distributions per year.
Cash value can only be used while living. Once the insured dies, any remaining cash value will be forfeited to the insurance company. Forfeited cash value helps to offset, or reduce, the total amount of financial liability on the insurance company when the death benefit is paid out to a designated beneficiary. Therefore, it is best for the policyowner to take advantage of the cash value in an insurance policy before the insured’s death.
It is more beneficial to use the cash source to payoff the insurance policy rather than use the loan source to payoff personal expenses. The loan source should only be used when a financial emergency arises as loans must be repaid with interest, and if not, take away from the death benefit provided to the designated beneficiary.
The purpose of the life insurance is income replacement, and more specifically, income replacement to your loved ones, not yourself. However, a person or business will purchase life insurance for their own present and/or future financial gain.