Cash Value Life Insurance Explained: Is It Worth it?
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What is cash value life insurance?
Cash value life insurance is a type of permanent life insurance that includes two main elements:
- A death benefit: The tax-free lump sum payout your beneficiaries receive when you pass away.
- A cash value component: A tax-deferred savings feature which grows over time and can be borrowed from or withdrawn while you’re still alive.
The most common types of cash value life insurance are whole life insurance and universal life insurance. These insurance policies are typically described as “an insurance product and an investment in one”. While this may sound appealing, cash value policies are often far more expensive than traditional life insurance policies, and generally unnecessary for the average Canadian.
No, the cash value of a permanent life insurance policy is not free money. Permanent life insurance policies with cash value components typically cost 5 to 15 times more than a term life policy because a portion of the premiums is used to fund the cash value savings component. On top of that, withdrawals or loans typically incur fees, interest, or a reduced death benefit.
How does cash value life insurance work?
Cash value life insurance policies split each premium payment into three parts:
- Insurance coverage: A portion of your premium covers your death benefit, which is the guaranteed tax-free lump sum that is paid out to your beneficiaries when you pass.
- Fees and administrative costs: Some of your payment covers the insurance provider’s fees and administrative costs.
- Cash value savings: The last portion is invested in the policy’s cash value, which grows over time in a tax-deferred savings account.
The cash value’s growth depends on the type of policy:
- Whole life: Offers growth at a minimum guaranteed rate.
- Universal life: Policyholders can choose their investment fund, so growth is linked to the market’s performance and carries more risk.
While whole life and universal life policies are generally complex and expensive, one of the main selling points of cash value life insurance is that it allows policyholders to use their savings component while they’re still alive. Policyholders can choose to:
- Withdraw from their cash value
- Borrow against it
- Use it as collateral for a loan.
Take note that withdrawals will lower the death benefit of a policy, and taxes may apply if you withdraw above a specific limit, surrender the policy, or if the policy lapses with an outstanding loan. We’ll get into this more in the following sections.
Lastly, participating whole life policies offer a separate component where you can earn dividends based on your life insurance company’s financial performance. Dividends can be used for the following:
- Taken as cash
- Used to buy more life insurance coverage (increase the death benefit)
- Used to reduce premium payments
- Used to increase the policy’s cash value
Bottom line: Cash value is funded by you and grows tax-deferred over time, based on the type of permanent policy.
How does the policy generate cash value?
Every time a premium is paid, part of it is added to the policy’s cash value account. This account grows on a tax-deferred basis at a fairly slow rate, especially at the beginning of the policy.
Most policyholders don’t see significant cash value growth until 10 to 15 years after buying the policy. This is because the bulk of the premium is used to cover the policy’s cost and administrative fees, and the amount added to the cash value fund with each premium payment is generally low.
The cash value’s growth rate depends on the type of policy you buy:
- Whole life: Whole life policies offer a guaranteed minimum rate of return, so the cash value’s growth is predictable and steady.
- Universal life: Cash value growth depends on the success of the chosen investment, which means growth potential is typically higher, but also riskier.
Yes. Some insurance providers offer limited-pay whole life insurance policies, which give you the option to pay up your premiums over a shorter period (e.g., 8, 10, 15, or 20-year pay plans). Since you’re paying higher premiums to the policy early on, the cash value can build sooner. The only drawback is that limited-pay policies are generally way more expensive than traditional whole life policies, which makes them unaffordable for most families.
Since you’re paying higher premiums to the policy early on, the cash value can build sooner. The only drawback is that limited-pay policies are generally way more expensive than traditional whole life policies, which makes them unaffordable for most families.
How do you borrow from the policy’s cash value?
Most insurance providers allow borrowing against the policy’s cash value. In this case, the policy’s cash value is used as collateral for the loan, and the insurance company charges an interest rate until it’s repaid.
It's important to note that the loan amount will reduce the policy’s coverage if you pass away before fully repaying the loan. The insurance provider will deduct the outstanding balance and the interest from the death benefit when you pass away.
And if your policy is surrendered, lapses, or matures while there’s an outstanding loan, the loan balance is treated as a withdrawal and a certain amount of the loan may be taxable.
On top of taking out a policy loan, there are a few ways to access your life insurance policy’s cash value. But keep in mind that each option has its drawbacks:
- Withdraw money: You can withdraw money from your cash value savings account, but this typically reduces the death benefit and may result in taxes if the withdrawal is larger than your adjusted cost basis (ACB).
- Use it as collateral for a bank loan: You may be able to use a portion of your policy’s cash value as collateral for a bank loan. But the bank sets the interest rate for a bank loan, which may be higher than the interest rates for a policy loan. And if you default on the loan, your insurance coverage may be at risk because the bank could seize the cash value.
- Use it to pay premiums: Some permanent policies permit the use of cash value or dividends to cover premiums, but this can slow the cash value’s growth.
- Surrender the policy for the cash surrender value: You can cancel your policy (also known as surrendering the policy) and receive the cash surrender value. But the cash value payout will be lower due to surrender fees, and your coverage and death benefit will be forfeited.
Your ACB is the total amount of premiums you’ve contributed to your policy (minus the cost of insurance and fees). When it comes to withdrawals, any amount you take out above your ACB is taxed as income. This income tax also applies to loans that are treated as withdrawals if the policy lapses, matures, or is surrendered.
Cash value vs. death benefit
A common misconception about cash value life insurance is that your beneficiaries get both the cash value and the death benefit when you pass away. In reality, they only receive the death benefit, as the cash value is returned to your insurance provider.
Here are the key features that differentiate the death benefit and cash value of a permanent life insurance policy:
Types of life insurance with cash value
There are three main types of life insurance that may offer cash value components:
How they grow: Cash values for whole life and participating life policies typically grow at a guaranteed rate. Universal life policies offer more investment options, so growth is often less predictable and riskier since it depends on market performance.
Pros and cons of life insurance with cash value
Cash value life insurance sounds good on paper, but there are a few downsides worth noting. Here’s what you should know before moving forward:
Cash value life insurance pros
Cash value life insurance cons
Is cash value life insurance worth it?
Cash value life insurance typically isn’t worth it for the average Canadian family. These types of policies are expensive, complicated, and rarely the best option for building wealth.
The “insurance plus an investment” aspect of cash value life insurance may seem like a two-in-one deal, but investment vehicles like RRSPs, TFSAs and RESPs offer much higher returns, and they don’t pose the costs of permanent policies.
And yes, some policies allow borrowing against your cash value, but you’ll have to pay interest on the loan. Borrowing can also work against the core purpose of life insurance if you don’t pay the loan back. Your death benefit will decrease, leaving your loved ones with a lower payout.
“[It is] the worst thing you can do … you’ll have to pay interest on the loan, and if you don’t pay all of it back, your death benefit will decrease. Think about how crazy this is – you’re paying interest on a loan made up of your own money.”– Dave Ramsey, Personal Finance Expert
Cash value policies also have a learning curve. You’ll need to understand complicated rules, added fees, and how the investment works, on top of paying higher premiums. A simpler term life policy can be easier to manage and offer the same coverage as a permanent policy, but at a much cheaper rate.
When does cash value life insurance make sense?
Cash value life insurance has its upsides, so it might make sense depending on your situation. Here are a few policyholder profiles that may align with a permanent policy that includes cash value:
- High-net-worth individuals: Cash value grows tax-deferred, so it may serve as another tax-sheltered investment if you’ve already maxed out your RRSPs, TFSAs and other traditional funds. Permanent life insurance can also support estate planning by providing a guaranteed death benefit, which can be especially beneficial if you’ll leave behind a large estate.
- Business owners: Permanent policies typically offer tax or estate planning perks for business owners who want to protect their company’s future. The business can borrow against the policy’s cash value and build the asset on a tax-deferred basis, while the death benefit safeguards the business.
Individuals with lifelong dependents, such as a family member with a disability, may also benefit from a permanent policy. But permanent policies that include a cash value component are complex, expensive and often unnecessary in these cases. If this sounds like your situation, consider a permanent life insurance plan that doesn’t include cash value, as they are typically way more affordable.
Term life insurance vs. cash value life insurance
Term life insurance offers coverage for a specific time period (typically between 10 and 30 years) and doesn’t include a cash value component. Due to its simplicity, term life coverage is usually much cheaper than whole life or universal life policies.
On top of its lower price point, term coverage is a popular option for Canadians because it aligns with the temporary financial needs of most people, and ends when those needs are settled.
For example, many policyholders take out a term policy when they have young dependent children or a new mortgage. By the time the term is done, their children are financially independent and their mortgage is nearly or fully paid off.
The biggest differences between term life and permanent life policies are the coverage periods, structure, and cost, but there are other aspects that set them apart. Here’s a side-by-side comparison:
In short, term life insurance balances affordability and protection. Lower term life premiums give you the option to invest your savings into smarter wealth-building vehicles, where you’re likely to see better returns compared to cash value growth.
PolicyMe offers some of the best term life insurance rates in Canada, with free, no-obligation quotes and an easy online application. You can review your coverage needs and explore the affordability of term life insurance in just a few clicks.
FAQ: Cash value life insurance
