Can I Pull Money Out of My Life Insurance?

Life insurance policies are primarily known for providing a financial safety net to beneficiaries. Certain types, however, can also accumulate a separate value that policyholders may access during their lifetime. Understanding how this component works and the ways it can be accessed is important.

Understanding Cash Value in Life Insurance

Cash value refers to a savings component within certain life insurance policies. This value grows over time, separate from the policy’s death benefit. A portion of each premium payment contributes to this cash value, which then accumulates interest or earns returns.

The way cash value accumulates varies depending on the type of permanent life insurance policy. Whole life policies typically grow cash value at a fixed, guaranteed interest rate. Universal life policies accumulate cash value based on current interest rates, offering more flexibility in premium payments and death benefits. Variable universal life and indexed universal life policies tie cash value growth to investment performance or market indexes, introducing potential for higher returns alongside greater risk.

Not all life insurance policies build cash value. Term life insurance, which provides coverage for a specific period, does not accumulate cash value. Only permanent life insurance policies, designed for lifelong coverage, include this feature.

Methods for Accessing Life Insurance Cash Value

Policyholders with permanent life insurance have several ways to access their accumulated cash value. These methods include taking a policy loan, making a cash withdrawal or partial surrender, or fully surrendering the policy.

One common method is taking a policy loan, where the policyholder borrows money from the insurer, using the cash value as collateral. Policy loans typically accrue interest, and any outstanding loan balance and accrued interest will reduce the death benefit paid to beneficiaries if not repaid.

Another option is a cash withdrawal, also known as a partial surrender. This allows the policyholder to directly withdraw a portion of the cash value. A withdrawal reduces the policy’s cash value and typically results in a corresponding decrease in the death benefit. Withdrawals are generally considered a return of premiums paid, which is called the “cost basis.”

Finally, a policyholder can choose to surrender the entire policy. Surrendering means terminating the life insurance coverage in exchange for the policy’s cash surrender value. The policyholder receives the accumulated cash value, minus any applicable surrender charges. Surrender charges are fees that may be imposed, especially if the policy is surrendered in its early years, and can significantly reduce the payout.

Tax and Policy Consequences of Accessing Cash Value

Accessing a life insurance policy’s cash value carries significant tax and policy implications. Any outstanding policy loan, if not repaid, will reduce the death benefit. Cash withdrawals or partial surrenders directly decrease the policy’s cash value and, consequently, reduce the death benefit. Full policy surrender eliminates the death benefit entirely.

Regarding tax implications, policy loans are generally not considered taxable income, provided the policy remains in force. However, if the policy lapses or is surrendered with an outstanding loan, the untaxed portion of the loan can become taxable. If a policy is classified as a Modified Endowment Contract (MEC), loans and withdrawals are taxed on a “last-in, first-out” (LIFO) basis, and a 10% federal penalty may apply to taxable gains if the policyholder is under age 59½. An MEC designation occurs when premiums paid exceed specific IRS limits within the policy’s first seven years, and this classification is irreversible.

For cash withdrawals, amounts up to the policy’s “cost basis” (the total premiums paid into the policy) are generally tax-free. Any amounts withdrawn that exceed this cost basis are considered taxable income. As with loans, withdrawals from an MEC are subject to LIFO taxation and potential penalties if taken before age 59½.

When a policy is fully surrendered, the cash surrender value received is taxable only to the extent it exceeds the policyholder’s cost basis. This gain is taxed as ordinary income. If the cash surrender value is less than or equal to the total premiums paid, there is generally no taxable gain.

A significant risk with both loans and withdrawals is policy lapse. If an outstanding loan balance, including accrued interest, grows to exceed the policy’s cash value, or if significant withdrawals reduce the cash value too much, the policy could lapse if premiums are insufficient to cover charges. This can lead to loss of coverage and unexpected tax liabilities on previously untaxed gains.