Life Insurance Cash Value: How It Works and When to Use It

What Is Life Insurance Cash Value?

Cash value is a savings component built into certain types of permanent life insurance policies. A portion of every premium payment you make goes into this cash value account, where it grows on a tax-deferred basis over the life of the policy. You can think of it as a savings account that lives inside your life insurance policy, accumulating money you can access while you are still alive.

Not every life insurance policy builds cash value. Term life insurance is pure protection. It pays a death benefit if you die during the term and builds no savings whatsoever. Only permanent life insurance policies — whole life, universal life, variable universal life, and indexed universal life — include a cash value component. Understanding how that cash value works, how it grows, and how to use it wisely is essential for anyone who owns or is considering a permanent life insurance policy.

Which Life Insurance Policies Build Cash Value?

Four main types of permanent life insurance build cash value. Each one handles the cash value component differently, which affects how fast it grows, how much risk is involved, and what returns you can expect.

Whole life insurance

Whole life insurance offers the most predictable cash value growth. The insurer guarantees a minimum interest rate, typically between 2% and 3% per year, and the cash value grows at that rate regardless of market conditions. Participating whole life policies from mutual insurance companies may also earn annual dividends that can be added to the cash value. The trade-off is that growth is slow compared to other policy types, but there is zero risk of loss. Your cash value will never decrease in a whole life policy.

Universal life insurance

Universal life insurance provides flexible premiums and a cash value that earns interest based on current market rates set by the insurer. The insurer declares a crediting rate, which can change periodically, subject to a guaranteed minimum floor that is typically between 1% and 3%. Universal life gives you more flexibility than whole life because you can adjust your premium payments and death benefit amount. However, if interest rates stay low for extended periods, cash value growth can be disappointing and may require higher premium payments to keep the policy in force.

Variable universal life insurance (VUL)

Variable universal life insurance invests your cash value in sub-accounts that function similarly to mutual funds. You choose from a menu of stock, bond, and money market sub-accounts. This gives you the potential for higher returns than whole life or standard universal life, but it also means your cash value can lose money when markets decline. VUL policies carry the most investment risk of any cash value life insurance product. They are best suited for people with a high risk tolerance and a long time horizon who understand that their cash value can fluctuate significantly.

Indexed universal life insurance (IUL)

Indexed universal life ties your cash value growth to the performance of a market index, such as the S&P 500, without directly investing your money in the stock market. If the index goes up, your cash value is credited with a portion of that gain, subject to a cap rate that is typically between 8% and 12%. If the index goes down, your cash value does not lose money because IUL policies include a floor, usually 0% to 1%. You give up some upside potential in exchange for downside protection. IUL offers a middle ground between the guarantees of whole life and the market exposure of variable universal life.

How Cash Value Grows Over Time

When you pay a premium on a permanent life insurance policy, that payment gets divided into three parts. The first portion covers the cost of insurance, which is the actual price of providing your death benefit. The second portion covers the insurer's administrative fees and expenses. The third portion is deposited into your cash value account.

In the first several years, the majority of your premium goes toward insurance costs and fees. Very little flows into the cash value. This is why cash value grows painfully slowly at the beginning. It is common for a policyholder to pay $10,000 in total premiums over the first few years and have a cash value of only $2,000 to $4,000. The heavy front-loading of costs is one of the most important things to understand about cash value life insurance.

As the years pass, the allocation shifts. More of your premium flows into the cash value account, and the compounding effect begins to accelerate growth. After 15 to 20 years, the cash value in a well-structured policy can grow to a substantial sum. By age 65 or 70, policyholders who have maintained their policies for decades may have cash values of $100,000, $200,000, or more depending on the premium amount and policy type.

Typical cash value growth rates by policy type

• Whole life: 2% to 3% guaranteed, potentially 4% to 6% with dividends from participating policies
• Universal life: 1% to 3% guaranteed minimum, with current crediting rates typically between 3% and 5% depending on prevailing interest rates
• Variable universal life: no guaranteed minimum, returns depend entirely on sub-account performance, historically ranging from negative returns in bad years to 8% to 12% in strong market years
• Indexed universal life: 0% to 1% guaranteed floor, with actual returns typically between 4% and 8% in years when the linked index performs well, subject to cap rates

All cash value growth is tax-deferred. You do not pay income tax on the gains each year as you would with a taxable brokerage account. This tax deferral is one of the primary financial advantages of cash value life insurance.

Cash Value vs. Death Benefit: What Is the Difference?

The cash value and the death benefit are two separate components of your life insurance policy, and understanding the distinction is critical. The death benefit is the amount paid to your beneficiaries when you die. The cash value is the savings component that you can access while you are alive.

Here is the part that surprises many policyholders: in most standard policies, your beneficiaries do not receive both the death benefit and the cash value. When you die, the insurer pays the face value of the policy — the death benefit — and retains the accumulated cash value. If you have a $500,000 policy with $80,000 in cash value and you die, your beneficiaries receive $500,000, not $580,000. The cash value effectively merges into the death benefit payout.

This means cash value is primarily a living benefit. Its value to you exists while you are alive, through loans, withdrawals, or surrendering the policy. If you never access the cash value during your lifetime, it does not provide any additional payout to your beneficiaries beyond the stated death benefit. Some insurers offer riders that pay both the death benefit and accumulated cash value, but these riders cost extra and increase your premium.

Outstanding policy loans also reduce the death benefit. If you have borrowed $40,000 against your $500,000 policy and die without repaying the loan, your beneficiaries receive $460,000.

How to Access Your Cash Value

There are three primary ways to access the cash value in your life insurance policy. Each method has different tax implications, impacts on your death benefit, and consequences for the future of your policy.

1. Policy loans

Policy loans are the most popular way to access cash value. The insurer lends you money using your cash value as collateral. You do not need a credit check, income verification, or approval process. The money can be used for any purpose. Interest rates on policy loans typically range from 5% to 8%, though some insurers offer lower rates on newer policies.

The key advantage of policy loans is the tax treatment. Loan proceeds are not considered taxable income by the IRS, regardless of how much you borrow. There is no mandatory repayment schedule either. You can repay the loan on your own terms or not repay it at all. However, any unpaid loan balance plus accrued interest is deducted from the death benefit when you die. If the loan balance grows to exceed your cash value, the policy will lapse.

2. Partial withdrawals

Many permanent life insurance policies allow you to withdraw a portion of your cash value directly. This is different from a loan because you are actually removing money from the policy rather than borrowing against it. Withdrawals up to your cost basis — the total premiums you have paid into the policy — are tax-free under the first-in-first-out (FIFO) rule. Any withdrawal amount above your cost basis is taxed as ordinary income.

Unlike policy loans, partial withdrawals permanently reduce your death benefit on a dollar-for-dollar basis. If you withdraw $20,000 from a $500,000 policy, the death benefit drops to $480,000. Some policies also charge a fee for withdrawals. Whole life policies are generally more restrictive about withdrawals than universal life policies, which tend to offer more flexibility.

3. Full surrender

Surrendering your policy means canceling it entirely and receiving the cash surrender value. The cash surrender value equals your accumulated cash value minus any surrender charges and outstanding loan balances. If you are considering this option, it is important to understand the full implications and explore alternatives first. Our guide on how to cancel life insurance covers the process and alternatives in detail.

Surrender charges are the biggest concern in the early years. Most policies impose declining surrender charges for the first 10 to 20 years. If you surrender a policy after just 5 years, you might receive back only 50% to 70% of your cash value after charges. After the surrender period ends, you receive the full cash value with no penalties.

When you surrender a policy, any amount you receive above your cost basis is taxed as ordinary income. For example, if you paid $50,000 in total premiums and receive a cash surrender value of $65,000, you owe income tax on the $15,000 gain.

Tax Implications of Accessing Cash Value

The tax treatment of life insurance cash value is one of its most important features. Understanding the rules can save you thousands of dollars and help you avoid costly mistakes. For a comprehensive overview of how life insurance interacts with taxes, see our guide on whether life insurance is taxable.

• Tax-deferred growth. Cash value grows without triggering annual income tax. You owe nothing to the IRS on gains as long as the policy remains active.
• Policy loans. Loan proceeds are not taxable income. However, if the policy lapses or is surrendered with an outstanding loan, and the total loan balance exceeds your cost basis, the excess is taxable as ordinary income. This is known as a phantom tax event because you owe taxes even though you did not receive any cash at the time of the lapse.
• Partial withdrawals. Withdrawals up to your cost basis are tax-free. Any amount above your cost basis is taxed as ordinary income. The IRS treats withdrawals on a FIFO basis, meaning your premiums come out first before any gains.
• Full surrender. The cash surrender value minus your cost basis is taxed as ordinary income in the year you surrender the policy. If you paid $60,000 in premiums over the years and receive a cash surrender value of $85,000, you owe taxes on the $25,000 gain.
• Death benefit. Under IRC Section 101(a), the death benefit is received by beneficiaries income-tax-free. Any cash value that was part of the policy is included in the death benefit payout and passes tax-free as well.
• Modified endowment contracts (MECs). If you fund a life insurance policy too aggressively, it can become classified as a modified endowment contract under IRC Section 7702A. MECs lose most of their tax advantages. Withdrawals and loans from a MEC are taxed on a last-in-first-out basis, meaning gains come out first and are taxed as ordinary income plus a 10% penalty if you are under age 59 and a half. Avoiding MEC status is critical when designing a cash value life insurance strategy.

Using Cash Value for Retirement Income

One of the most commonly discussed uses of life insurance cash value is supplementing retirement income. The strategy works like this: you build cash value over 20 to 30 years of premium payments during your working years, then take policy loans in retirement to create a tax-free income stream. Because policy loans are not taxable income, they do not increase your adjusted gross income, do not affect Social Security taxation thresholds, and do not count toward Medicare surcharge calculations.

This can be genuinely valuable for high-income retirees who have already maxed out their 401(k), IRA, and other tax-advantaged retirement accounts. Adding a layer of tax-free income from policy loans can reduce overall taxes in retirement and provide financial flexibility.

However, there are important caveats. Policy loans accrue interest, which compounds over time and can erode both the cash value and the death benefit. If you borrow too aggressively, the loan balance can exceed the cash value and cause the policy to lapse, triggering a substantial tax bill. You also need to keep paying premiums or ensure the policy is paid up before retirement. The strategy requires careful management and regular monitoring of the policy's health.

For most people, traditional retirement accounts like a 401(k) or IRA should be fully funded before using cash value life insurance as a retirement tool. The tax deduction on 401(k) contributions, employer matching, and the generally higher investment returns available in diversified portfolios make those accounts more efficient. Cash value life insurance works best as a supplementary retirement income source, not a primary one.

When to Use Your Cash Value

There are legitimate situations where tapping into your cash value makes good financial sense.

• Emergency fund of last resort. If you face a true financial emergency and have exhausted other options, a policy loan can provide quick access to cash without the credit checks and approval delays of traditional loans.
• Supplementing retirement income. After maxing out other retirement accounts, policy loans can provide tax-free income in retirement. This works best with substantial cash value built over decades.
• Funding a child's education. Some parents use cash value to help pay for college. Unlike 529 plan withdrawals, policy loan proceeds do not affect financial aid calculations under FAFSA.
• Paying premiums. If you face a temporary cash flow crunch, some policies allow you to use cash value to cover premium payments, keeping the policy in force without out-of-pocket spending.
• Business opportunities. Business owners sometimes use policy loans to fund business investments, equipment purchases, or cash flow needs. The loan can be repaid from business profits.

When to Leave Your Cash Value Alone

In many situations, the smartest move is to leave your cash value untouched and let it continue compounding.

• Early in the policy. In the first 10 to 15 years, your cash value is relatively small and surrender charges are high. Accessing cash value during this period provides minimal benefit and can jeopardize the policy.
• When you need the death benefit. If your family depends on the full death benefit, taking loans or withdrawals reduces what they will receive. Protecting the death benefit should take priority over accessing cash value for discretionary spending.
• When cheaper alternatives exist. Policy loan interest rates of 5% to 8% are higher than many home equity lines of credit or other secured loans. If you can borrow more cheaply elsewhere, it may make sense to do so instead of tapping your cash value.
• For non-essential spending. Borrowing against your life insurance to fund a vacation, buy a luxury item, or cover a want rather than a need is almost never a good financial decision. The interest compounds, the death benefit shrinks, and the long-term cost far exceeds the short-term gratification.

Common Mistakes With Cash Value Life Insurance

Cash value life insurance is a powerful financial tool, but it is also one of the most commonly misunderstood products in personal finance. Here are the mistakes that trip people up most often.

• Assuming cash value and death benefit are separate payouts. Many policyholders believe their beneficiaries will receive the death benefit plus the cash value. In most policies, the death benefit is the only payout. The cash value is absorbed by the insurer at death.
• Surrendering too early. Canceling a policy in the first 10 to 15 years almost always results in a financial loss. Surrender charges eat into your cash value, and you lose the long-term compounding that makes these policies worthwhile. If you must exit the policy, explore options like a 1035 exchange into a different policy or a reduced paid-up option before surrendering.
• Over-borrowing against the policy. Taking too many loans without repaying them can cause the loan balance to exceed the cash value, leading to a policy lapse. A lapse with a large outstanding loan can create a phantom tax event where you owe taxes on the forgiven loan amount without receiving any cash.
• Buying cash value insurance before maximizing retirement accounts. A 401(k) with employer matching, a Roth IRA, and an HSA all offer superior tax advantages for most people. Cash value life insurance should supplement these accounts, not replace them. Only consider it as a savings vehicle after all other tax-advantaged options are fully funded.
• Ignoring the policy illustration's guaranteed column. Insurance agents often present projections based on non-guaranteed assumptions — current dividend scales, optimistic crediting rates, or strong index performance. The guaranteed column shows the worst-case scenario and should be the basis for your decision. If the policy does not make sense using guaranteed values, it is too risky.
• Triggering MEC status accidentally. Overfunding a policy by paying more than the IRS-defined seven-pay test limit converts it into a modified endowment contract. Once a policy becomes a MEC, it cannot be reversed, and you lose the favorable tax treatment on loans and withdrawals. Work with a knowledgeable advisor to ensure your premium payments stay within safe limits.
• Not monitoring universal life policies. Unlike whole life, universal life policies can lapse if the cash value cannot cover the cost of insurance. Rising insurance costs as you age combined with lower-than-expected interest crediting can drain the cash value faster than anticipated. Review your annual policy statement and be prepared to increase premiums if necessary to keep the policy healthy.

The Bottom Line

Cash value is one of the most powerful and most misunderstood features of permanent life insurance. It provides tax-deferred growth, flexible access through loans and withdrawals, and the potential to supplement your retirement income. But it comes with genuine complexity, costs that are front-loaded into the early years, and risks that can catch uninformed policyholders off guard.

The policies that build cash value — whole life, universal life, variable universal life, and indexed universal life — each offer different risk and reward profiles. Whole life gives you guarantees and stability. Universal life gives you flexibility. Variable universal life gives you market upside with market risk. Indexed universal life gives you a middle path with downside protection.

If you already own a cash value policy, understand how to access it wisely. Favor policy loans over withdrawals when possible for their tax advantages. Avoid over-borrowing. Monitor your policy annually. And never surrender a policy without first exploring alternatives like reduced paid-up insurance or a 1035 exchange.

If you are considering buying a cash value policy, make sure your basic financial priorities are handled first. Term life insurance to cover your family's immediate needs, emergency savings, employer-matched retirement contributions, and debt management should all come before investing in cash value life insurance. Once those foundations are solid, cash value life insurance can be a valuable addition to a well-rounded financial plan.