How Does Life Insurance Accumulate Cash Value?
One of the additional benefits to purchasing certain types of life insurance, beside the obvious death benefit, is the accumulation of cash value. Unfortunately, the manner in which cash accumulates within a policy, and the reasons policies are structured in such a manner, are too often overlooked or poorly explained.
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Term vs. Permanent
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Several different types of life insurance policies exist, and each one has its appropriate place in filling specific needs. However, all policies fall into one of two broad categories: term or permanent. Term insurance is the simplest and least expensive, whereas permanent products are much more complex and usually more expensive. Term policies typically don't last forever; imagine that "term" is short for "terminate." You're covered for a pre-determined period of time, the term, at the end of which you stop paying and the carrier stops insuring you. Permanent policies, on the other hand, last forever. They build equity in the form of cash value and will never expire.
Why Cash Accumulates
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When you first buy a permanent policy, especially at a young age, you are many years ahead of life expectancy, which gives the carrier plenty of time to use your premium to generate capital. As you grow older, you approach the end of your natural life expectancy. This reduces the time your insurance company has to invest your premium dollars to generate enough money to pay your family the policy's death benefit. As you get older, the internal cost of your coverage dramatically increases. To maintain a level premium, permanent life insurance policies charge you more in the beginning than is technically necessary. That excess money is set aside in a cash value account, where the policy then withdraws it as necessary in the later years when your premium contribution is insufficient to cover the internal cost of the plan.
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Getting That Money
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Permanent life insurance contracts are structured to account for the possibility that you may choose to withdraw the cash value. Most carriers will permit withdrawals up to 80 or 90 percent of the accumulated cash, and some even allow you to withdraw all but one dollar. Getting and using the cash value is as simple as submitting a completed request form. No income or capital gains taxes are generated from the withdrawal because the carrier structures it as a loan.
Returning That Money
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If you choose not to repay a cash value loan, the insurance company decreases your policy's death benefit by the amount of the outstanding loan. Failure to repay large loans may actually have a negative impact on your family's financial security because of the smaller death benefit. Additionally, if you cancel your policy before repaying the cash value loan, you might end up owing taxes if the outstanding loan is greater than your premium contributions.
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