Cash value life insurance, also known as whole life insurance or permanent life insurance, is a type of life insurance policy that builds up a cash value over time. The policy holder can borrow against this cash value or even cash it out. This type of policy is different from term life insurance which only provides a death benefit and does not build cash value.
While cash value life insurance seems appealing, there are some downsides to this type of policy that policyholders should be aware of. In certain situations, cash value life insurance can be a poor financial decision for consumers.
High Premium Costs
One of the main downsides of cash value life insurance is that premiums are typically much higher than term life insurance. This is because part of the premium goes towards the cash value, in addition to the death benefit coverage.
Premiums are also level for the life of the policy, meaning they do not decline with age like term insurance. Premiums for a $500,000 policy could start at $10,000 per year for a 40 year old. This is significantly higher than a similar term policy.
The high premium costs mean purchasing cash value life insurance policies requires a major financial commitment. Consumers take on this large expense but may see little return on the cash value itself.
Low Returns on Cash Value
The returns earned on the cash value account are generally quite low, especially compared to returns seen in the stock market. Insurance companies typically only credit between 4-6% back on the cash value.
After deducting the insurance company’s expenses and profit margins, the policyholder’s cash value often grows minimally over decades. The cash value may not even keep pace with inflation in some cases.
Therefore, policyholders sacrifice higher investment returns they may have otherwise earned on the money spent on premiums. The cash value itself becomes an ineffective investment vehicle.
Penalties for Surrendering Policy
If a policyholder decides to surrender their cash value policy and cancel it, there are usually surrender charges incurred. These surrender fees can remain in effect for many years, often as long as 10-15 years of the policy.
The surrender penalties mean if someone pays into the policy for years but has to stop paying premiums, they can lose a chunk of their cash value to fees. The “guaranteed cash value” amount touted by insurance agents assumes keeping the policy for.
Tax Treatment of Gains
Any gains made on withdrawals or loans taken against the cash value are subject to ordinary income tax rates. If the policy is surrendered and cashed out, tax applies to all gains above the cost basis.
This can result in hefty tax bills compared to the preferential treatment given to long-term capital gains and qualified dividends in stock portfolios or 401ks. Policyholders lose out on tax deferral benefits other investments provide.
Opaque Fees & Charges
Cash value life insurance is notorious for being complex and opaque regarding the myriad fees charged to policyholders. Annual cost of insurance fees often reduce the cash value. Mortality and expense charges also eat away at cash value each year.
In addition, the interest rate credited on cash value is declared by the insurance company annually. It may change over time, but the interest credited often lags behind market interest rates. All these hidden charges mean the cash value growth is uncertain.
Considering the high cost structure and ineffective growth, there are typically better places to put your savings unless you have a clear need for permanent life insurance.
For most situations, consumers are better off using low-cost term life insurance and investing the premium difference in stocks, mutual funds, or real estate. These provide better transparency and growth potential compared to obscure cash value accounts.
When Can Cash Value Policies Make Sense?
Cash value life insurance does not make sense for most policyholders, but there are some exceptions where it may be beneficial. These include:
- Very high net worth individuals who have maxed out other tax-advantaged savings vehicles and can benefit from the tax-deferred growth in the cash value.
- Business owners who use cash-value policies to fund buy-sell agreements or provide key person insurance.
- Those with a concrete need for life insurance into very advanced ages when term insurance becomes prohibitively expensive or unavailable.
Outside of specialized cases, cash life insurance is generally not a prudent financial move compared to and conventional investing. Consumers should consider their options carefully.
Cash value life insurance policies tend to come with high premium costs, low returns, surrender charges, tax inefficiencies, and confusing fees. While they have their niche uses, they are often poor choices for most policyholders who have other means to meet their life insurance needs and save for retirement. Consumers are usually better off using paired with other investments rather than permanent cash value life insurance.
Q1: Why is Cash Value Life Insurance Bad?
Cash value life insurance is often considered unfavorable because it tends to have higher premiums compared to. Additionally, a significant portion of the premium payments goes towards fees and the cash value component, which may not provide the best return on investment.
Q2: What are the drawbacks of Cash Value Life Insurance?
The drawbacks of cash value life insurance include limited flexibility in premium payments, lower investment returns compared to other investment options, and the potential for the policy to lapse if is insufficient to fund the premiums.
Q3: Is Cash Value Life Insurance a good investment?
Cash value life insurance is not typically viewed as a strong investment option because the returns on component are often lower than what can be achieved through alternative investment vehicles like stocks or bonds.
Q4: Can I access the cash value in my life insurance policy?
Yes, you can access in your life insurance policy through policy loans or withdrawals, but doing so may reduce the death benefit and could have tax implications. It’s essential to understand the terms and consequences before accessing the cash value.
Q5: What alternatives are there to Cash Value Life Insurance?
Alternatives to cash life insurance include term life insurance, which offers lower premiums and a straightforward death benefit, and investing in separate financial vehicles like 401(k) plans, IRAs, or other investment accounts for potential higher returns.