Can I Cash Out My Term Life Insurance Policy?

Life insurance policies offer financial protection, but their features vary. Many inquire about “cashing out” term life insurance, often assuming it functions like a savings account. Understanding term life insurance clarifies why this is not possible.

Understanding Term Life Insurance

Term life insurance provides coverage for a specific period, such as 10, 20, or 30 years. Its primary purpose is to offer a death benefit to beneficiaries if the insured person passes away within that defined term. It is considered “pure protection” because premiums cover insurance costs and administrative expenses.

Premiums for term life policies are level throughout the contract duration, remaining constant for the chosen term. These payments are calculated to cover the risk of death during the term, based on factors like age, health, and lifestyle. Without a savings or investment component, term life insurance does not accumulate cash value.

At the end of the specified term, the policy expires, and coverage ceases. While some term policies offer options for renewal, these renewals often come with significantly higher premiums due to the insured’s increased age. Policies also offer conversion to a different type of coverage.

Comparing Term and Permanent Life Insurance

Term and permanent life insurance differ primarily in duration and cash value. Term life provides temporary coverage without cash value. It meets specific, time-limited financial protection needs.

Permanent life insurance, encompassing types like whole life and universal life, offers coverage that can last for the insured’s entire life, provided premiums are paid. A portion of the premiums paid into a permanent policy is allocated to a savings or investment component. This forms the policy’s cash value, which grows on a tax-deferred basis over time.

Permanent policies’ accumulated cash value can be accessed by the policyholder during their lifetime. Options include policy loans, withdrawals, or surrendering the policy. This cash value access distinguishes permanent policies from term life.

Options for a Term Life Insurance Policy

Term life policies do not build cash value, so “cashing out” is not an option. However, policyholders have choices if they no longer need coverage, including terminating the policy or transitioning to a different type.

One straightforward option is to let the policy lapse. This occurs if premium payments stop and the grace period expires. If a term policy lapses, the coverage ends, and the policyholder receives no refund for the premiums already paid.

Another option is to convert the term policy into a permanent life insurance policy, such as whole life or universal life. Many term policies include a conversion privilege, allowing this transition without requiring a new medical examination. This means that even if the insured’s health has declined, they can secure permanent coverage. The new permanent policy would then begin to accumulate cash value over time, which the policyholder could eventually access through loans or withdrawals.

A policyholder might sell their term life policy through a life settlement. This process involves selling an existing policy to a third-party investor for a lump-sum payment. The payment received is more than the policy’s surrender value (zero for term policies) but less than the full death benefit. After the sale, the buyer becomes the new policy owner, assumes responsibility for future premium payments, and receives the death benefit when the insured passes away. Life settlements are available to older policyholders (65+) or those with a terminal illness.

Tax Considerations for Term Policies

Understanding tax implications is important when considering term life policy options, especially if money is received. For life settlements, the proceeds are subject to taxation. The Internal Revenue Service (IRS) outlines a three-tier approach for taxing these proceeds.

First, the portion of the sale proceeds up to the total premiums paid into the policy (known as the cost basis) is received tax-free. Any amount received above this cost basis, up to the policy’s cash surrender value, is taxed as ordinary income. For term policies with no cash surrender value, any gain above premiums paid is taxed as a capital gain. Viatical settlements, for terminally or chronically ill policyholders, are tax-exempt.

Converting a term policy to a permanent policy is not a taxable event at conversion. However, if the new permanent policy builds cash value and funds are accessed via withdrawals or loans, tax rules apply. Withdrawals are tax-free up to premiums paid; amounts exceeding this are taxed as ordinary income. If a policy with an outstanding loan lapses, the loan amount exceeding premiums paid can become taxable income. Due to the complexities of tax regulations, consulting a qualified tax professional is advisable for personalized guidance.