How cash value works

The surprise

On most permanent policies, your beneficiaries receive the death benefit — not the death benefit plus the cash value. The cash value is generally absorbed by the insurer at death.

So decades of accumulation doesn't add to what your family gets, unless you hold a policy with an increasing death benefit option that specifically includes the account value.

That's not a scandal; it's how the product is priced. But it changes how you should think about cash value: it's money for you while living, not an inheritance.

How it accumulates

• Whole life — guaranteed growth on a contractual schedule, plus dividends on participating policies, which aren't guaranteed
• Universal life — an account credited with interest, less the cost of insurance and expenses each month
• Indexed universal life — credits linked to an index, subject to caps, floors and participation rates
• Variable universal life — invested in subaccounts, with real market risk

The early years

Cash value in the first several years is typically far below the premiums paid, because acquisition costs and charges come out first. Surrender charges usually apply for a number of years on top.

Ask for the guaranteed cash surrender value at year five and year ten before buying. That table tells you more about the product than the illustration does.

Getting at it

• A policy loan — not taxable while the policy stays in force, and it reduces the death benefit if unpaid
• A withdrawal — generally taxed on a first-in, first-out basis, and it permanently reduces cash value and usually the death benefit
• Surrender — ends the coverage, and gain above basis is generally taxable as ordinary income
• Non-forfeiture options — reduced paid-up coverage, or extended term, which keep some coverage without further premiums

The loan-plus-lapse trap

A policy with a large outstanding loan that lapses or is surrendered generally triggers a taxable gain — a bill on money borrowed and spent years earlier, with no policy left and no cash to pay it.

If you have a loan against a policy, request an in-force illustration and ask directly what happens if it lapses. This is the failure mode worth understanding in advance, because afterwards there's nothing to be done.

The non-forfeiture options people don't know about

If you can no longer afford the premiums, surrendering isn't the only option. Reduced paid-up coverage converts the cash value into a smaller permanent policy with no further premiums. Extended term uses it to keep the current death benefit for a defined period.

Both keep some coverage in place. Ask about them before surrendering anything.