Cash value: what it is and what it costs

Permanent life insurance combines a death benefit with an accumulating cash value. Understanding how that accumulation works, and what it costs, is essential to evaluating whether the product suits you.

Where the premium goes

Each premium is allocated among several things.

Cost of insurance, the mortality charge for the death benefit at risk. This rises with age.

Expenses and administrative charges, including policy fees and premium loads.

Commission, which is front-loaded — a large share of first-year premium in most permanent products.

The remainder, which credits to cash value.

Because expenses and commission are heavily front-loaded, cash value in the early years is typically very low and frequently zero for the first year or two.

This is why surrendering a permanent policy early produces almost nothing back, and why the break-even point is often a decade or more out.

How cash value grows

Depends on the product type.

Whole life credits a guaranteed minimum rate, with participating policies also paying non-guaranteed dividends. Dividends have been paid consistently by many mutual insurers historically, and they are not guaranteed.

Universal life credits a declared rate that the insurer can adjust, subject to a guaranteed minimum.

Indexed universal life credits interest based on the performance of an index, subject to a cap on the upside, a floor protecting against loss, and a participation rate.

The caps and participation rates are generally adjustable by the insurer, which means illustrated returns based on current caps may not persist.

Variable universal life invests in subaccounts with market exposure. Cash value can decline, and if it declines far enough the policy can lapse, requiring additional premium to maintain.

Reading an illustration honestly

Illustrations show columns of projected values. Only one of them is a promise.

Look at the guaranteed column, which assumes minimum credited rates and maximum charges. This is the worst case the insurer can impose, and it is frequently much less attractive than the illustrated one.

The non-guaranteed column assumes current rates continue indefinitely. Historically, credited rates and dividend scales have declined over long periods.

Specific things to check:

Cash surrender value in years one through ten, guaranteed. Frequently near zero for several years.

The surrender charge schedule and how long it runs, which can be a decade or more.

Whether the illustration assumes premiums are paid every year, and what happens if one is missed.

Ask for an in-force illustration periodically after purchase, showing actual performance against the original projection.

Accessing cash value

Withdrawals. Generally tax-free up to basis — the total premiums paid — with amounts above that taxable.

Withdrawals reduce the death benefit.

Policy loans. Borrowing against cash value. Generally not taxable while the policy remains in force, which is the basis of much of the marketing around these products.

Loans accrue interest. Unpaid loans plus interest reduce the death benefit.

The significant risk: if the policy lapses or is surrendered with an outstanding loan, the loan amount above basis generally becomes taxable income — potentially a large tax bill on money already spent.

This happens, and it happens to people who took loans in retirement and then could not sustain the premiums.

Surrender. Ending the policy for its cash surrender value, less surrender charges. Gain above basis is taxable.

The modified endowment contract issue

If a policy is funded too quickly relative to its death benefit, it becomes a modified endowment contract under tax rules.

The consequence is that distributions, including loans, are taxed on a gain-first basis and may be subject to an additional penalty before a certain age.

This is a technical trap that arises with over-funded policies, and it is permanent once triggered.

The honest comparison

The relevant question is the internal rate of return on the cash value component, net of all costs, compared with alternatives.

Over long holding periods, whole life cash value has historically produced modest returns — generally lower than diversified market investments, with substantially less volatility and with a death benefit attached.

That combination has value for some purposes. It is not equivalent to an investment account, and presentations comparing illustrated cash value growth to market returns without accounting for the costs are misleading.

Ask directly: what is the internal rate of return on cash value at year twenty, on the guaranteed basis and on the current basis?

A good agent will produce it. The number is frequently informative.

If you already own one

Do not surrender reflexively. The costs are already paid, and the ongoing return on cash value going forward may be reasonable even if the early years were poor.

Options include: continuing as is; reducing the death benefit to lower ongoing costs; using dividends to reduce premium; converting to a paid-up policy; or a tax-free exchange to a different policy under section 1035, which preserves basis.

Get an in-force illustration and independent advice from someone with no commission interest before acting.

General information about insurance products, not insurance, financial or tax advice. Policy mechanics and tax treatment are technical and vary. Consult a licensed advisor and a tax professional.