Whole life cash value: how it grows and how to use it

Whole life cash value is a savings reserve inside the policy. It grows on a schedule written in your contract, plus dividends if the policy pays them, and it is tax-deferred. It starts near zero, usually takes years to catch up with the premiums you have paid, and you can reach it through a policy loan, a withdrawal or a surrender, each with different effects on your death benefit and taxes.

How cash value builds

Your premium pays for the cost of insurance, the insurer's expenses and commissions, and the reserve. The reserve is the cash value. Because acquisition costs are front-loaded, the first one or two years often show little or no cash value. Growth then accelerates because the reserve earns interest and the insurer's cost of covering you is spread over a larger fund.

Three layers can contribute:

• Guaranteed cash value. The minimum schedule in the contract. Insurers must hold reserves to back it, and state nonforfeiture law sets a floor.
• Dividends. On a participating policy, dividends declared by the insurer can be used to buy paid-up additions riders explained, which add their own cash value. Dividends are not guaranteed. See whole life dividends: how participating policies pay.
• Paid-up additions rider. An optional rider that lets you pay extra premium into small blocks of paid-up coverage, each with its own cash value.

A hypothetical illustration of the timing

Say a policy has a guaranteed cash value schedule like this one. The numbers are invented to show the shape, not any company's product.

In this example the owner who surrenders in year 5 loses $11,000 relative to premiums paid, and the break-even arrives after year 10. Real schedules vary: a policy designed with a lot of paid-up additions can show higher early cash value and a lower death benefit per premium dollar. Check the in-force numbers in your own illustration. See how to read a life insurance illustration and how to request and read an in-force illustration.

Four ways to use cash value

1. Borrow against it

A policy loan is a loan from the insurer with your cash value as collateral. You are not withdrawing your own money, so the cash value normally keeps growing, though some insurers adjust credited interest or dividends on the borrowed portion. There is no credit check and no required repayment schedule, but the loan interest accrues. If the loan plus interest grows larger than the cash value, the policy can lapse. An unpaid loan at death is subtracted from the death benefit.

Loan interest rates are set by the contract, either fixed or variable, and differ by insurer. Compare the loan rate with the credited rate on borrowed value, because the spread is the true cost. The policy loan calculator shows how a loan balance compounds.

2. Withdraw part of it

Some policies allow partial withdrawals, but whole life usually limits them to dividends or paid-up additions. A withdrawal reduces both cash value and, in many contracts, the death benefit. See withdrawing cash value from a life insurance policy.

3. Surrender the policy

Surrendering cancels coverage and pays you the cash surrender value, which is the cash value minus any loans and surrender charges. If you receive more than your cost basis (generally the premiums you paid, less dividends received in cash and prior withdrawals), the gain is taxable as ordinary income. Details are in surrendering a life insurance policy: what you get and what it costs and how cash value is taxed: withdrawals, loans and surrenders. Consider alternatives such as a 1035 exchanges: swapping policies without tax or nonforfeiture options: reduced paid-up and extended term before you give up coverage.

4. Use it to pay premiums

Dividends or cash value can sometimes cover premiums, and an automatic premium loan can keep the policy from lapsing. See automatic premium loans. This helps in a short crisis, but relying on it for years can drain the policy.

How cash value is taxed

The general rules, which an adviser should confirm for your situation:

• Growth is tax-deferred while it stays inside the policy.
• A policy loan is generally not taxable income as long as the policy stays in force and is not a modified endowment contracts and the 7-pay test.
• A surrender or withdrawal that exceeds your basis is taxable.
• If the policy lapses or is surrendered with a loan outstanding, the loan counts as a distribution, and any gain over basis becomes taxable, even though you receive no cash. This is a known trap for older policies with large loans.
• A policy that fails the seven-pay test becomes a MEC and loses the favorable loan treatment. Whole life that is paid in a normal level pattern usually passes, but single-premium and heavily funded policies may not. See seven-pay test and section 7702.
• The death benefit remains generally income-tax-free to beneficiaries. See is life insurance taxable?.

What cash value is not

It is not a separate account you can leave to heirs on top of the death benefit. It is not a high-return investment: the guaranteed growth is modest, and the long-run result depends heavily on dividends if any, on holding the policy for decades and on expenses. whole life as an investment: what the returns really are looks at realistic returns. It is also not fully liquid in the early years.

Cash value may also count as an asset for some needs-based programs. See medicaid eligibility and life insurance cash value. Many states protect some cash value from creditors, but the rules vary, so check your state or see can creditors take life insurance money?.

Checklist before you tap your cash value

1. Request an in-force illustration and confirm the current cash value, loan balance and loan rate.
2. Ask whether a loan reduces dividends or credited interest.
3. Decide how you will repay the loan, and set a ceiling below which the loan stays well under the cash value.
4. Ask whether the policy is a MEC.
5. Ask your tax professional what a surrender would trigger.

Key takeaways

• Whole life cash value grows on a contractual schedule, plus dividends if any, and is tax-deferred.
• It is usually low in the first years, so surrendering early often returns less than you paid.
• Policy loans are generally tax-free while the policy stays in force, but unpaid loans reduce the death benefit and can cause a lapse.
• A surrender or lapse with a large loan can create a tax bill even if you receive no money.
• Cash value is part of the policy, not an extra payout at death.