The primary goal of life insurance is to pay a lump sum to your beneficiaries after you die. However, it is not the only reason to purchase insurance. According to a new Insuredcircle study, 23% of Americans who buy life insurance do so to build cash value and save for retirement.

However, while life insurance can be used as an investment vehicle, it is not the best option for everyone. Learn how cash value works and whether this is the right investment for you.

How does life insurance work as an investment?

Life insurance is classified into two types: term and permanent. While both pay out death benefits, only permanent life insurance can grow an investment.

Because permanent policies, such as whole life insurance, include an investment component known as cash value. A portion of your premium is allocated to the cash value, which grows tax-free. You can withdraw or borrow against the funds to cover expenses while you are still alive.

There is no cash value in term life insurance policies. This type of coverage is less expensive than permanent coverage and lasts for a set period of time, such as 20 or 30 years. When looking for insurance, you may hear the phrase "buy term and invest the rest." This strategy entails purchasing a term life insurance policy and investing the money you would have spent on a permanent policy in something else, such as stocks. Speak with a fee-only financial advisor to determine whether this investment strategy is appropriate for you.

Why should life insurance not be used as an investment?

Life insurance may not be the best way to build wealth depending on your coverage and investment needs. Here are three critical factors to consider before investing in life insurance.

1. If you don't require the insurance, there may be better investment options available. The primary goal of life insurance is to leave money to your beneficiaries. If you don't need the coverage, you might want to look into other types of investments first.
2. The cash value doesn't pass to your heirs. The cash value of your policy is not usually added to the death benefit. It's a separate investment component that you can access while you're still alive. However, the two are frequently linked. If you withdraw money from the cash value or take out a loan and do not repay it, the death benefit is reduced by the same amount or more. Using the cash value to pay your premiums has no effect on your death benefit.
3. Cost and eligibility typically depend on your age and health. To obtain coverage, you may be required to take a medical exam, which is not required for traditional investment vehicles such as a 401(k).

Using life insurance to save for retirement

If you purchase a permanent policy when you are young, the cash value may increase significantly by the time you retire. While cash withdrawals reduce the death benefit, you may no longer require the insurance component and would prefer to access the cash value instead. You can use the funds to cover a variety of expenses.

Flexible cash withdrawals. You can use the money in your account for whatever you want and withdraw it whenever you want. This is not always the case with other retirement vehicles, such as a traditional IRA, which requires you to begin taking minimum distributions in your early 70s. If you withdraw funds from an IRA or 401(k) before reaching a certain age, you may face a tax penalty. In contrast, withdrawals from life insurance cash value are not subject to the same restrictions.

Tax-free withdrawals. Without paying income tax, you can withdraw up to the policy basis (the amount of money you've paid into the policy). If you withdraw more than the policy basis, you may have to pay tax on the gains.

Tax-free cash value loans. You can take out a loan if you want to withdraw more than the policy basis but avoid paying tax on the gains. These loans are not taxable as income, but they do accrue interest, which can accumulate over time. The policy may lapse if the loan exceeds the total cash value. As a result, it is recommended that you pay at least the annual interest to keep the loan from growing. You are not obligated to repay the loan. Nonetheless, if you die before repaying it, the remaining balance is usually deducted from the death benefit, leaving your life insurance beneficiaries with a lower payout.

Important: A life insurance investment account may not be sufficient to fully support your retirement. Speak with a fee-only financial advisor to find the best retirement plan for you.

Get the most out of your cash value growth

Some insurers allow you to choose the rate at which the cash value grows. For example, in a whole life policy, you may be able to pay all of your premiums over the first ten years, or even all at once in a single premium, boosting cash value growth. However, keep in mind that if you pay your individual premiums over a shorter period of time rather than spreading them out, your individual premiums will be higher.

Important: If you overfund your life insurance policy, the IRS may classify it as a modified endowment contract. If this occurs, you may be subject to additional taxes and fees for withdrawing funds from the cash value too soon.

If you choose a mutual insurance company that is owned by policyholders, you may be able to build cash value through dividends. These companies typically pay annual dividends to whole life policyholders, which can be used to purchase paid-up additions or PUAs. These are essentially small amounts of permanent life insurance that are paid up with dividends and can increase the value of your investments overall.

Types of life insurance policies you can use as an investment

The rate at which cash value grows is determined by the type of policy you have, the length of time you've had coverage, the amount you pay into the account, and the terms of your specific policy.

Whole life insurance: Because it is the most straightforward type of permanent coverage, some people use it as an investment. It has fixed premiums, a death benefit that is guaranteed, and cash value growth.

Cash value: The cash value grows at a fixed rate determined by the insurer. Because the interest rate is fixed, the investment is not subject to market fluctuations.

Universal life insurance is a more adaptable version of permanent life insurance. In universal life insurance policies, the death benefit, premiums, and cash value are not guaranteed. Instead, if your needs change, you can adjust your premiums and death benefit within certain limits.

Cash value: Interest is typically earned on the cash value based on money market rates. These rates can fluctuate, making it a riskier investment than whole life insurance. Some insurers, however, set a minimum interest rate, such as 2%, to protect the investment from severe losses.

Variable universal life insurance is a type of universal life insurance. It, like universal life, allows you to set your premiums and death benefit within certain limits. You can also choose how to invest the money, giving you more control over the investment.

Cash value: The cash value earns interest based on the performance of the insurer's investment fund options, such as stocks and bonds. Depending on the policy, the insurer may establish minimum interest rates.

Indexed universal life insurance is a subset of universal life insurance that provides similar coverage flexibility but differs in how the cash value earns interest.

Cash value: The cash value growth is based on the performance of stock indexes like the S&P 500. To protect the investment from market losses, these policies typically have interest floors, such as 0%. They may also have maximum interest rates, known as caps.

Variable life insurance provides a variety of investment options for the cash value, but unlike universal life insurance, you cannot adjust your premiums. Variable life insurance typically carries higher investment risks than other types of permanent coverage.

Cash value: Interest is earned on a variety of investment sub-accounts provided by the insurer, such as indexes, stocks, bonds, and mutual funds. To help mitigate severe losses, insurers may set minimum and maximum rates.

One of the many reasons people buy life insurance is to make an investment. Here are some additional common reasons for purchasing insurance.

• Utilizing life insurance to supplement your income
• Burial insurance is used to cover final expenses.
• Purchasing life insurance in order to pay off debt
• Using life insurance to leave a legacy