How does the cash value component of a permanent policy work?

Many people consider life insurance as a tax-free financial safety net for their loved ones in the event of their premature death. And they aren’t wrong.

But life insurance can be more than just paying out a death benefit, depending on the type of policy you choose. 

Permanent life insurance policies, such as whole life or universal life, offer a “cash value component” as well as a “guaranteed death benefit.” 

This gives you the best of both worlds. The death benefit offers financial protection to your loved ones, while the cash value component allows you access to living benefits.   

What does that mean, and how do these policies work? Let’s dive in!

What is Cash Value in Permanent Life Insurance? 

Permanent life insurance offers lifetime coverage. This means that your policy will pay out a guaranteed death benefit, unlike term life insurance. Permanent policies have no expiry date and last for as long as the policyholder is alive.

As the death benefit is guaranteed, permanent life insurance policies tend to have higher premiums than a term policy. This would make them less attractive if not for the cash value component.

Now, instead of all those premium payments going directly towards covering your death benefit, a percentage of those payments is deposited into a cash account, which can grow tax-deferred over time. 

This cash account is referred to as the cash value component of a permanent policy, and it can have many uses. 

How Does Cash Value Work?

Cash value isn’t like a bank savings account. 

A typical savings account allows you to earn a fixed interest and withdraw your cash whenever you want, normally without any fees or repercussions. This isn’t the case here. 

Cash value is more of a long-term investment account that can take at least a few years before you see any meaningful buildup.  

How Cash Value Grows?

Cash deposited into the account from premium payments is invested and can grow from credited interest, dividends (in participating whole life), or investment performance (in universal life). 

Actual growth can depend on many factors, including funding level, fees, cost of insurance, time in the policy and how the policy was designed in the first place.

Some permanent life insurance policies, for example, build cash value faster through higher early funding, while others may be designed mainly for pure protection or retirement. Some even offer index-linked accounts and other investment options, depending on the carrier and contract. 

As such, it is always advisable to consult with a trusted insurance broker before locking down a permanent policy.

When and How to Withdraw from Your Cash Value?

Withdrawing from a cash value account isn’t as straightforward as, let’s say, a bank savings account. Using the funds within a cash value account can cause reductions in coverage and future growth. It can also create taxes depending on when and how you access it. 

Instead of withdrawing directly, you can tap into your cash value component in other ways. The three most common access paths are policy loans, withdrawals, or policy surrender. Each has tradeoffs. Let’s break it down.

1. Take out a Policy Loan (Best Method)

Instead of withdrawing from your cash value account directly, risking future growth and potentially high taxes, you can instead borrow against a portion of the cash value (not the full amount). These loans usually have lower interest rates than banks, are tax-free, and do not require credit checks. While you will still have to pay some interest, interest payments could potentially cost you less than the taxes and fees you would otherwise have to pay if you withdrew directly. This can also allow you to keep your coverage and cash value intact. Be aware, though, that unpaid loans can reduce the death benefit and can cause problems if the policy lapses.

2. Do Partial Withdrawals (For Immediate Cash)

Take out the money in small chunks. As long as you withdraw less than the amount of premiums you have paid (“basis”), you won’t be taxed. However, any amount exceeding “basis” would be taxed as income. While this can be handy in emergencies, it isn’t ideal. It can reduce the death benefit your beneficiaries would receive, and it can impact the future growth of your cash value. 

3. Surrender the Policy (The Last Resort)

If you no longer need life insurance, can’t make the premium payments, or need to tap into your entire cash value at once, you can cancel the policy to receive a cash surrender value. This is usually cash value minus fees, loans, or other charges like “early surrender fees” that can apply to some policies. You should only do this as a last resort because when you can cancel your policy, you lose out on the death benefit entirely, which will usually be a lot more than whatever you would have had in your cash value account.

Why is Cash Value Useful?

The death benefit paid directly to a beneficiary of a life insurance policy is not taxable income. Cash value can also work the same way, as it grows tax-deferred inside the policy. Whatever you pay into it isn’t taxed. Only the gains you make are taxed as ordinary income.

So, while taxes may apply when you withdraw, surrender, or sometimes borrow, depending on the situation and the policy’s adjusted cost basis (ACB), they don’t if you just withdraw up to your basis. 

This can be extremely useful in situations where you need cash or low-cost credit quickly, or during retirement, as it can act as an additional tax-free retirement income. 

Cash value offers a lot more flexibility and is also extremely beneficial for transferring generational wealth to family members and managing estate needs.

When is Permanent Life Insurance a Good Fit?

Wealthy Nova Scotian families or high-net-worth individuals looking for stable, long-term, structured savings, combined with lifetime protection, are ideal candidates for permanent life insurance. This type of policy offers greater flexibility, more coverage options and can even act as an instrument for estate and legacy planning. 

Permanent life insurance policies aren’t a good fit for Nova Scotian households that have tight budgets or only short-term coverage needs. Term life insurance would be a lot more suitable as these policies are less complicated, term-based, and more affordable.

Consult with Halifax’s Most Trusted Insurance Broker

If you are considering buying a life insurance policy, whether a term or permanent one, always consult with an experienced and trusted insurance broker. 

Life insurance policies can be complex and difficult to compare, especially if you don’t understand policy mechanics and risks. This can have detrimental long-term implications that can be easily avoided with professional guidance.

At McIver Insurance we start by understanding your unique situations and real financial goals. Only then can we find the right insurance solution for your health, lifestyle, and finances from a range of reputable providers.

We also work with your accountant or financial advisor when tax and business planning are part of the picture and help walk you through premium structure, expected values, and realistic tradeoffs.

To get in touch, call now or click here to book a FREE no-obligation meeting. 

FAQs 

Q1) Is cash value guaranteed?

In most cases, yes. Some growth is usually guaranteed, but the percentage can vary based on dividends, interest crediting, or market-linked performance.

Q2) Can I use cash value any time?

In theory, yes. But access rules can vary. Loans and withdrawals may only be made available once sufficient value builds, and it can also affect coverage and taxes.

Q3) Will a policy loan trigger tax?

It may or may not. Tax outcomes vary based on the policy, ACB, and how the loan is structured, especially if the policy is later surrendered or lapses.

Q4) What’s the difference between cash value and cash surrender value?

Cash value is the accumulated cash amount inside the policy. Cash surrender value is what you may receive if you cancel your policy, i.e. after deductions like fees, charges, and loans.