How Life Insurance With Cash Value Works

My car is dripping a suspicious liquid and we’re overdue for a $5,000 home maintenance project. My mother’s reminder that “these things come in threes” is ringing in my head, so I’m wondering what other unexpected expense might drop in my lap soon. Sometimes even when you plan finances carefully, multiple one-time bills hit at once, and it helps to know where extra cash could come from if you need it.

Life insurance is an important part to help protect loved ones in case of your death, but some types of life insurance can offer cash value . Policies with a cash value component can offer policy loans and withdrawals if you use them carefully. Please keep in mind that withdrawals may be subject to charges and interest is charged on loans, they may generate an income tax liability, reduce the account value and death benefit, and may  cause the policy to lapse.    

If a policy loan is an option for you, here’s how to take advantage of that resource if you need it, and how to do it wisely.

What Is Cash Value?

All life insurance policies have a face value. That’s the death benefit, or the amount of money that goes to a beneficiary when the policy owner passes away. Some types of permanent life insurance also have a cash value that builds over time and you may be able to access. , 

Cash value comes from part of your premiums. Permanent life insurance (e.g., whole life, universal life insurance) is typically more expensive than a term life insurance policy for the same face value, because coverage doesn’t expire after a set number of years. Permanent life insurance premiums go in part to the cost of the policy plus fees and overhead for the insurer, and partly to a cash value component. 

The cash value grows either at a fixed rate or following the performance of market investments, depending on what kind of policy you have. It takes some time to accumulate, but if funded properly  you can withdraw from cash value to cover premiums or borrow against it for whatever reason you like. You can also decide to take the whole cash value (minus any surrender fees) and surrender your policy, ending your coverage.

When you die, your beneficiaries get the death benefit, but the insurance company generally keeps the cash value component. If you repay the loans, you can have access to some extra cash when you need it and avoid taking away from the eventual death benefit to your loved ones.

Term life insurance has a face value or death benefit, but it doesn’t accumulate a cash value, so you can’t use it to take out a loan because you don’t have anything to borrow against.

How Life Insurance Loans Work.

Borrowing and repayment terms

With a life insurance loan, you’re essentially “borrowing” from yourself, The insurance company lends you the money and uses the cash value component you’ve already accumulated as collateral. The maximum loan amount you can take is based on a percentage of your cash value (90 percent is typical).

There isn’t a specific repayment schedule, so you can pay back the loan on your own timeline. You do typically have to pay interest, which commonly ranges from around 5 to 8 percent. 

The main thing to watch out for is if the interest accumulates to the point that your loaned amount is bigger than the cash value in your policy. That could cause your policy to lapse, which would leave you without coverage and could trigger tax implications.  Please consult a tax advisor based on your situation.  

Are cash value loans taxable?

You generally don’t have to pay income tax on a life insurance loan, as long as your policy stays active. One important distinction to know is your “policy basis,” or the sum of your payments into the cash value, and the gains. If your policy lapses, you’ll face taxes on the gains.

If you have a cash value of $50,000 and your policy basis is $40,000, you’d have $10,000 of taxable income. This is sometimes called “phantom income” because you can find yourself with a tax bill without seeing much of the money. A situation might happen like this:

1. You take out a life insurance loan against your cash value to help with bills or financial goals. The insurer lends you money from their general fund, so you might not see the loan reflected in your cash value.

2. Over time, you realize it’s too difficult to keep up with premium payments on your policy. You decide to surrender the policy and take the cash value.

3. The insurance company notes your outstanding loan, with whatever interest you’ve accrued, and subtracts that from the amount you receive.

4. Even though you see a much smaller check than the total cash value, the IRS still treats all of the gains as taxable income because you surrendered the policy.

It’s best to stay on top of interest payments at a minimum to keep your policy from lapsing and leaving you on the hook for taxes. It’s also important to note that if your life insurance policy meets criteria to count as a modified endowment contract (MEC), you’ll face different tax implications that can get complicated and are best to discuss with a financial professional.

What Happens If You Don’t Pay a Loan Back?

You’re not on a payment schedule, so an insurance company won’t “foreclose” on your policy if you don’t start paying back a loan right away. So what happens if you borrow money from your cash value and just don’t pay it back?

For one, you could end up losing your coverage. If you don’t make repayments and the interest accumulates, your borrowed amount could creep up past your cash value total. If your outstanding balance is too high, your policy will lapse. At that point, you’d also face taxes on any amount over your “investment in the contract,” meaning your premium payments into the cash value. If you’ve already spent the money from what you intended to be a tax-free loan, it can be challenging to face a tax bill on thousands of dollars or more in cash value gains.

If your policy is still active but you have an outstanding loan when you die, the insurance company deducts the loan amount from the death benefit your loved ones receive. A life insurance payout usually isn’t taxable, so beneficiaries won’t have to pay taxes on a loan amount over your policy basis. They just get a lower benefit, dollar for dollar, as the insurance company collects the outstanding loan balance amount with any interest. This can mean you and loved ones face less in taxes than if you surrendered the policy, but you’d be leaving less of a benefit for your loved ones than you planned.

Is Borrowing Against Cash Value a Good Idea?

Taking a life insurance loan against cash value can be a low-hassle way to get extra cash if you need it. You don’t have to deal with credit checks or a strict repayment schedule, and interest rates may be lower than some other types of loans (e.g., some personal loans, credit card interest rates). 

Downsides to keep in mind are that your loan amount is limited based on how much is in your cash value, so a life insurance loan may not give you all the funds you need for a major project. You also need to keep on top of payments or risk losing your coverage and facing a potentially large tax bill.

If you’re paying for permanent life insurance, part of the benefit is having a cash value component that can accrue tax-deferred growth and that you can access in your lifetime. If it makes sense for your goals, a life insurance policy loan can be a reasonable way to access some extra cash when you need it, as long as you play your cards right.

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