How cash value life insurance works
Term life insurance pays a death benefit amount but doesn’t come with a cash value component, according to the Insurance Information Institute. Permanent life insurance, by comparison, can provide both death benefits and accumulated cash value savings by combining an investment component with a life insurance policy.
As you pay your policy premiums, the insurance company separates the payment into separate “buckets.” Part of the money goes toward the death benefit, and another part goes toward building cash value in your policy. A small portion also goes toward the insurer’s operating costs and fees.
The cash value component accrues over time and grows tax-deferred, according to the National Association of Insurance Commissioners (NAIC). The money in the cash value account grows tax-free until you withdraw the funds. If you’re thinking about withdrawals from your life insurance policy, talk to a financial advisor or tax specialist to discuss potential tax consequences.
See More: Types of Term Life Insurance
Can I borrow money from my life insurance policy?
As your cash value grows, you can use it to pay premiums or borrow against it for other expenses. You may borrow from your cash value life insurance policy if you need quick access to funds and want to avoid taking out a loan. You can use it for various purposes, such as medical bills, home improvement projects, and college tuition expenses.
The process is relatively simple and doesn’t rely on credit checks. The exact steps for borrowing vary depending on your life insurance company, but you usually begin the process by contacting your insurance agent or broker to ask for the loan. You aren’t removing money from your cash value account. Instead, the insurer gives you a loan, using the cash value as collateral.
For example, suppose Linda wants to borrow from her cash value life insurance policy to help fund a down payment on a house. She submits a request in writing and receives the money in her bank account. She’ll make payments to repay the balance and any interest charges, until she pays it off.
However, Linda must consider the drawbacks before borrowing from her life insurance policy. Her insurer could cancel the policy if she doesn’t make payments on time. And if she doesn’t repay the loan before she dies, her beneficiaries could receive a reduced death benefit.
Cash value and taxes
Cash value life insurance policies grow tax-deferred, so you won't typically need to pay taxes on gains. The money you withdraw from the policy isn’t usually taxable unless you take out more than the premiums you paid. If you sell the policy or surrender it for cash value while you’re still alive, you’ll likely have to pay taxes on any gains you made.
Your beneficiaries receive life insurance death benefits tax-free, according to the IRS. This means that when you pass away, your loved ones will receive the full amount of the life insurance death benefit without having to pay any taxes on it.
Learn More: Life Insurance and Taxes: Everything You Need to Know