In addition to death benefit protection, one of the most useful features of many universal life (UL) insurance policies is their ability to build up cash value. 

Understanding the role cash value plays in a life insurance policy, and knowing the advantages and disadvantages of using the cash value can help you better maximize the value you receive from your life insurance.

Where does the cash value in a universal life insurance policy come from?

Quite simply, you start the process of building cash value in your universal life insurance policy by making premium payments.

A portion of your premium goes toward covering your policy’s expenses, but anything above that goes toward building cash value in your policy. It's important to actively pay enough premiums or have enough cash value in reserve to cover the policy’s expenses.  Otherwise, your policy may lapse.

Not all universal life insurance policies are designed to build cash value — the closer your premiums are to the costs of the protection you’re purchasing, the less opportunity there is to grow your account value.

Since life insurance is primarily designed to provide protection and is not an investment, there are also limits on the amount of extra premium you can put into a policy to build cash value. Those limits are based on guidelines set by the Internal Revenue Code.  

How can the cash value grow?

Your policy’s cash value has opportunities to earn interest, based on the design of your coverage. Some universal life insurance policies are designed to be more conservative, and offer competitive, steady interest rates. On the other hand, indexed universal life insurance may offer higher interest-earning potential, but the interest crediting may be less predictable. 

No matter how your universal life insurance earns interest, the growth inside of the policy will be tax-deferred as long as your coverage remains in effect. And, when the policy is structured and used properly, you can use your cash value for tax-advantaged policy loans and partial withdrawals — neither are currently considered federally taxable income. Because tax law can be complex and potentially change, be sure to consult with your attorney or tax advisor on the best approach for you.

What roles can cash value play in a life insurance policy?

Building cash value in your universal life policy can enhance the living benefits, the flexibility and the security of your coverage. Here are a few of the ways you might use your cash value:

Cover future policy expenses – Unlike certain types of whole life insurance, most universal life insurance policies require that you pay premiums for the life of your contract. However, that doesn’t mean you have to pay those premiums out-of-pocket. The cash value in your policy can help cover these charges too.

Supplement your retirement income – Within limits, policy loans and partial withdrawals can be used to create an income stream in retirement without being subject to taxation. Read more about the uses of life insurance in retirement here. 

Help cover education expenses – With a bit of early planning and preparation, the cash value in a universal life insurance policy can be a cost-effective way of helping to fund the education of someone you care about. Generally, the cash value in a life insurance policy is not included in financial aid calculations.  

A useful emergency fund – The cash value in permanent life insurance can help give you financial security when unexpected financial needs arise. Unlike loans from a bank, there is no credit check or income verification required to access the cash value of your life insurance policy. This ensures that you have access to the money when you need it most.

A few additional points to consider

When properly funded and structured, utilizing your cash value can enrich the value you receive from your universal life insurance policy. But it’s also important to understand that distributions impact how your policy works.

Taking distributions from your policy, whether by loans or withdrawals, will reduce your available cash value and the death benefit your beneficiaries will receive. Distributions may also negatively affect the performance of your policy, requiring additional premiums to be paid to keep your coverage in force. 

While mentioned earlier in the article, it bears repeating — universal life policies have some expenses that are charged for the life of the policy, and you must either be actively paying premiums to cover those expenses, or have enough cash value to cover them. Otherwise, your coverage may lapse and create tax liabilities.

That’s why working with a financial professional, and seeking guidance when appropriate from an attorney or tax advisor, can help decide whether utilizing the cash value potential in a universal life insurance policy is right for your strategy.