Adjusted cash value

What Is Adjusted Cash Value?

Adjusted Cash Value, within the realm of Life Insurance and Financial Planning, refers to the net value of a permanent life insurance policy's cash value after accounting for various deductions or additions. This adjustment typically considers factors such as outstanding policy loans, unpaid premiums, or any applicable surrender charges that would reduce the amount a policyholder would actually receive if the policy were to be surrendered or terminated. It represents the accessible or net amount available to the policyholder at a given point, differing from the gross cash value which does not include these deductions. The concept of adjusted cash value is crucial for understanding the true liquidity and potential tax implications of a permanent life insurance policy.

History and Origin

The concept of "cash value" in life insurance policies emerged alongside the development of whole life and other permanent insurance products, designed to offer coverage for an insured's entire life rather than a specific term. Early forms of whole life insurance, which built up a reserve over time, began to gain prominence in the late 19th and early 20th centuries. As these policies matured, the accumulated reserve became a source of value that policyholders could access. The regulatory landscape for life insurance in the United States is largely governed at the state level, with the National Association of Insurance Commissioners (NAIC) playing a significant role in promoting uniformity across state laws and regulations since its establishment in 1871. The NAIC has historically developed model laws and regulations to help standardize insurance practices, including those pertaining to policy reserves and cash values, in response to evolving market needs and consumer protection concerns.⁴ The notion of "adjusted cash value" became relevant as policy features like policy loans and surrender charges became common, requiring a clear understanding of the net amount available to a policyholder after these considerations.

Key Takeaways

• Adjusted Cash Value represents the net amount of a life insurance policy's cash value available to the policyholder.
• It accounts for deductions such as outstanding policy loans, unpaid premium payments, and surrender charges.
• Understanding the adjusted cash value is important for assessing the true liquidity and financial utility of a permanent life insurance policy.
• This figure is crucial for calculating potential taxable gains if a policy is surrendered or lapses with an outstanding loan.

Interpreting the Adjusted Cash Value

Interpreting the Adjusted Cash Value requires understanding that it is not merely the accumulated cash value shown on a policy statement. Rather, it reflects the practical, usable value. If a policyholder chooses to surrender their Whole Life Insurance or Universal Life Insurance policy, the adjusted cash value is the amount they would receive after any applicable surrender charges and outstanding policy loans are subtracted from the gross cash value. Similarly, when a policy loan is taken, the loan amount reduces the available cash value, effectively adjusting it downwards.

For tax purposes, particularly if a policy lapses with an outstanding policy loan, the adjusted cash value can become relevant. If the outstanding loan exceeds the premiums paid into the policy, the difference could be considered taxable income by the IRS. The IRS Publication 525 provides guidance on what constitutes taxable and nontaxable income, including discussions on life insurance proceeds and the tax implications of certain policy actions.³ Therefore, the adjusted cash value provides a more realistic assessment of the policy's financial benefit to the policyholder, distinct from the larger, theoretical gross cash value.

Hypothetical Example

Consider Sarah, who owns a permanent life insurance policy with a current gross cash value of $50,000. She took a policy loan of $10,000 some time ago, which remains unpaid. Additionally, if she were to surrender the policy now, there would be a surrender charge of $2,000.

To calculate the adjusted cash value:

Gross Cash Value: $50,000
Outstanding Policy Loan: $10,000
Surrender Charge: $2,000

Adjusted Cash Value = Gross Cash Value - Outstanding Policy Loan - Surrender Charge
Adjusted Cash Value = $50,000 - $10,000 - $2,000 = $38,000

In this scenario, the adjusted cash value for Sarah's policy is $38,000. This is the amount she would actually receive if she decided to surrender her policy today, demonstrating how the raw cash value is "adjusted" by deductions.

Practical Applications

The concept of Adjusted Cash Value has several practical applications in financial planning and insurance management:

• Policy Surrender Decisions: When a policyholder considers surrendering a permanent life insurance policy, understanding the adjusted cash value is critical to determine the net payout. This figure directly impacts the financial outcome of such a decision.
• Loan Management: For policies with outstanding policy loans, the adjusted cash value reveals the remaining accessible funds or the net value if the policy were to be terminated. It helps policyholders understand the true burden of their loan and its impact on the policy's death benefit. Financial Industry Regulatory Authority (FINRA) offers resources to help consumers understand the implications of life insurance policy loans.
• Tax Planning: If a permanent life insurance policy lapses with an outstanding loan, the loan amount exceeding the premiums paid into the policy can become taxable income tax. The adjusted cash value, in this context, helps in assessing potential tax liabilities. The IRS provides specific guidance on the tax treatment of life insurance proceeds and policy loans in its publications.²
• Estate Planning: While the primary focus of estate planning with life insurance is often the death benefit, understanding the adjusted cash value can be relevant if there's a possibility the policy might need to be accessed or surrendered during the insured's lifetime. It provides clarity on the liquid value available.

Limitations and Criticisms

While providing a clearer picture of a policy's net worth, the concept of Adjusted Cash Value inherently carries some of the limitations and criticisms associated with permanent life insurance itself. A common critique often comes from financial professionals who advocate for "buy term and invest the difference," arguing that the internal costs and fees associated with building cash value within a policy can be higher compared to separate investment vehicles.¹

One significant limitation is the impact of surrender charges, particularly in the early years of a policy. These charges can significantly reduce the adjusted cash value, meaning that the policyholder may receive less than the total premiums paid if the policy is surrendered prematurely. Furthermore, outstanding policy loans permanently reduce the adjusted cash value and, consequently, the death benefit if not repaid. If a policy lapses due to an unpaid loan, any loan amount exceeding the policy's basis (typically premiums paid) may become immediately taxable, which can be an unexpected tax-deferred growth consequence for policyholders. This underscores the need for careful consideration and understanding of the policy terms before taking loans or surrendering a policy.

Adjusted Cash Value vs. Cash Surrender Value

While often used interchangeably in general conversation, "Adjusted Cash Value" provides a more nuanced view than "Cash Surrender Value."

Cash Surrender Value represents what an insurance company pays out when a policy is terminated, typically after deducting initial costs and any surrender fees. Adjusted Cash Value takes this a step further by also incorporating outstanding policy loans and other debits, providing the truest picture of the net liquidity a policyholder can access from their life insurance asset at any given moment.

FAQs

What causes a policy's cash value to be "adjusted"?

A policy's cash value is primarily "adjusted" by outstanding policy loans (reducing it), unpaid premiums (reducing it), and any applicable surrender charges if the policy is being terminated.

Is Adjusted Cash Value the same as the policy's "book value"?

No, "book value" is a term more commonly associated with a company's financial accounting, representing its assets minus liabilities. Adjusted Cash Value specifically refers to the net accessible cash value of a permanent life insurance policy after specific deductions.

Can the Adjusted Cash Value be negative?

The adjusted cash value cannot be negative in the sense of the policyholder owing money when surrendering a policy. However, if outstanding loans exceed the cash value, the policy could lapse, leading to potential tax implications on the portion of the loan that exceeds the premiums paid.

How does a policy loan affect the Adjusted Cash Value?

A policy loan reduces the adjusted cash value dollar-for-dollar by the outstanding loan amount. This means less cash value is available for withdrawal or surrender, and the death benefit would also be reduced by the outstanding loan if the insured passes away.

Is the Adjusted Cash Value subject to taxes?

The Adjusted Cash Value itself is not taxed. However, if a policy is surrendered and the Adjusted Cash Value (after deducting premiums paid) is positive, that gain may be subject to income tax. Additionally, if a policy lapses with an outstanding loan, the portion of the loan exceeding the policy's cost basis (premiums paid) can be considered taxable income.