Can I Cash In My Life Insurance Policy?

Many individuals view life insurance primarily as a means to provide financial protection for their beneficiaries. However, certain types of life insurance policies offer an additional feature: the accumulation of cash value. Understanding how this cash value works and the ways it can be accessed is important for those considering their financial options, as it offers financial flexibility but involves various considerations.

Life Insurance Policies with Cash Value

Cash value in a life insurance policy represents a savings component that builds up over the policy’s lifetime. A portion of each premium payment you make is allocated to this cash value account, distinct from the portion covering the cost of insurance and administrative fees. This accumulated value grows on a tax-deferred basis, meaning you do not pay taxes on the earnings as they accrue. The growth mechanism for the cash value can vary depending on the specific type of policy.

Several types of permanent life insurance policies are designed to build cash value:
Whole life insurance offers a guaranteed cash value growth rate and a fixed premium.
Universal life insurance provides flexibility in premium payments and death benefits, with cash value growth often tied to an interest rate.
Variable universal life insurance allows policyholders to invest the cash value in sub-accounts, offering potential for higher returns but also greater risk.
Indexed universal life insurance ties cash value growth to a market index, often with caps on gains and floors for losses.

In contrast, term life insurance does not accumulate cash value. It provides coverage for a specific period, typically 10 to 30 years, and pays a death benefit only if the insured passes away within that term. Once the term expires, coverage ends, and there is no accumulated value to access. Only permanent life insurance policies offer a living benefit through their cash value component.

Methods of Accessing Cash Value

Policyholders have several distinct methods to access the cash value accumulated within their permanent life insurance policies. One common approach is taking a policy loan. This involves borrowing funds directly from the insurer, using the policy’s cash value as collateral. The policy remains in force, and interest accrues on the outstanding loan balance.

Another method is making a withdrawal from the cash value. This involves directly removing funds from the policy’s accumulated value. When a withdrawal is made, it reduces both the policy’s cash value and, in most cases, the death benefit that would be paid to beneficiaries. Unlike a loan, a withdrawal does not need to be repaid.

A third option is to surrender the policy for its cash surrender value. This action involves terminating the entire life insurance contract. Upon surrender, the policyholder receives the accumulated cash value, less any surrender charges and outstanding loans. Once the policy is surrendered, all insurance coverage ceases, and no death benefit will be paid in the future.

Financial and Tax Implications of Accessing Cash Value

Accessing the cash value of a life insurance policy involves specific financial and tax considerations that vary by the method chosen. For policy loans, the borrowed funds are not considered taxable income as long as the policy remains in force. This tax-free treatment applies up to the policy’s cost basis, which is the total amount of premiums paid into the policy. However, if the policy lapses or is surrendered with an outstanding loan, the loan amount exceeding the cost basis can become taxable.

A significant exception to the tax-free loan rule applies to policies classified as Modified Endowment Contracts (MECs). An MEC arises if a policy is funded too quickly, exceeding specific IRS limits. Loans and withdrawals from MECs are treated as taxable income first, up to the amount of gain in the policy, before any return of basis. Additionally, distributions from an MEC before the policyholder reaches age 59½ may be subject to a 10% federal income tax penalty, similar to withdrawals from qualified retirement plans.

When making withdrawals from a policy’s cash value, the funds are tax-free up to the amount of the premiums paid, representing a return of your cost basis. Any amount withdrawn that exceeds the cost basis is considered taxable income and is taxed as ordinary income. This is often referred to as a “last-in, first-out” (LIFO) rule for tax purposes, meaning earnings are presumed to be withdrawn before principal.

Surrendering a policy for its cash value also has tax implications. If the cash surrender value received exceeds the total premiums paid into the policy (your cost basis), the difference is considered a taxable gain. This gain is taxed as ordinary income in the year the policy is surrendered. For example, if you paid $50,000 in premiums and receive $60,000 upon surrender, the $10,000 gain would be taxable income.

Impact on Your Life Insurance Coverage

Accessing the cash value within a life insurance policy directly impacts the coverage provided and the policy’s long-term viability. When you take a policy loan, any outstanding loan balance, along with accrued interest, will reduce the death benefit paid to your beneficiaries. This means that while you gain access to funds during your lifetime, the financial protection intended for your loved ones is diminished by the amount of the unrepaid loan.

Similarly, making withdrawals from your policy’s cash value directly reduces the death benefit. Each dollar withdrawn decreases the amount your beneficiaries will receive, an immediate and permanent effect.

Depleting the cash value through loans or withdrawals can also introduce a risk of policy lapse. Permanent life insurance policies often use cash value to cover ongoing charges, such as the cost of insurance and administrative fees, especially if premium payments are stopped. If the cash value becomes insufficient, the policy could lapse, leading to a complete loss of coverage.

Completely surrendering a policy for its cash value results in the termination of all life insurance coverage. No death benefit will be paid to beneficiaries, as the contract is dissolved. If you later decide to obtain new life insurance, it may be more expensive or difficult to qualify due to changes in age and health.