How does whole life insurance and cash value work?

This answer is about Life insurance.

How the cash value builds

Part of every whole life premium funds the death benefit and expenses, and part goes into the policy's cash value. The cash value grows on a schedule guaranteed in the contract and accumulates on a tax-deferred basis under U.S. tax rules — you generally don't pay income tax on the growth as long as it stays inside the policy.

Accessing the cash value

• Policy loans — borrow against the cash value; loans accrue interest and reduce the death benefit if unpaid.
• Withdrawals — you can withdraw up to your cost basis (premiums paid) generally income-tax-free; amounts above basis may be taxable.
• Surrender — you can cancel the policy and take the cash surrender value, minus any surrender charges; gains above basis are taxable.

Participating whole life and dividends

Whole life issued by a mutual insurer is often 'participating': the company may declare non-guaranteed annual dividends. Dividends can be taken in cash, used to buy paid-up additional insurance (PUAs), left to accumulate at interest, or applied to reduce premiums. Dividends are not guaranteed and depend on the insurer's investment, mortality, and expense experience.

When whole life makes sense

• You have a lifelong need for a death benefit (e.g., estate liquidity, leaving a legacy, funding a special-needs trust).
• You've maxed out other tax-advantaged accounts and want tax-deferred cash-value growth.
• You want a stable, guaranteed premium and death benefit with predictable cash-value growth.

What to watch out for

Whole life is a long-term product: early-year cash value is often small relative to premiums paid, and surrendering in the first several years usually means a loss. Make sure the premium fits your long-term budget, since lapsing a whole life policy after paying for years can waste much of the value.