Can I Take Money From My Life Insurance?

Life insurance policies primarily offer a financial safety net for beneficiaries upon the policyholder’s passing. Certain types of policies also build a component that can be accessed during the policyholder’s lifetime. Accessing these accumulated funds requires understanding the policy’s structure and available methods.

Policies with Cash Value

Certain life insurance policies include a savings component known as cash value, which accumulates over time. This cash value represents a portion of the premium payments that grows on a tax-deferred basis. It can serve as a living benefit, offering a financial resource to the policyholder.

Whole Life insurance builds cash value at a guaranteed rate. A fixed portion of each premium payment is allocated to the cash value, which grows predictably over the life of the policy. Universal Life policies offer more flexibility, allowing policyholders to adjust premium payments and death benefits, with the cash value growth often tied to an interest rate declared by the insurer. Variable Universal Life policies link the cash value growth to investment sub-accounts chosen by the policyholder, meaning its value can fluctuate with market performance. Term life insurance policies do not build cash value because they are designed to provide coverage for a specific period without a savings component.

Accessing Cash Value: Loans, Withdrawals, and Surrender

Policyholders have several direct methods to access the accumulated cash value within their life insurance policies. These methods include taking a policy loan, making a cash withdrawal, or surrendering the policy entirely. Each option has distinct implications for the policy’s coverage and its future value.

A policy loan allows the policyholder to borrow money using the cash value as collateral. The loan uses the cash value as security, meaning the policy generally remains in force. Interest accrues on the outstanding loan balance. Unpaid interest can be added to the loan principal, potentially reducing the death benefit or causing the policy to lapse if the loan value exceeds the cash value. To initiate a policy loan, the policyholder contacts the insurer, completes a loan request form, and may receive funds within a few business days, often up to 90% of the available cash value.

A cash withdrawal directly removes funds from the policy’s cash value. This action permanently reduces the policy’s cash value and the death benefit paid to beneficiaries. Withdrawals are generally taken from the policy’s cost basis first, which represents the total premiums paid into the policy. To request a withdrawal, the policyholder contacts the insurance company, submits a withdrawal request form, and specifies the amount desired.

Policy surrender involves canceling the life insurance policy entirely in exchange for its cash surrender value. When a policy is surrendered, the death benefit coverage terminates. The policyholder receives the accumulated cash value minus any surrender charges or outstanding loans. Surrender charges are fees imposed by the insurer for early termination, which typically decrease over the initial years. The process requires a formal request to the insurer, often involving a surrender form.

Tax Implications of Accessing Funds

Understanding the tax implications of accessing funds from life insurance is an important aspect of financial planning. The tax treatment varies significantly depending on the method used to access the policy’s value. These rules are generally applied at the federal level.

Policy loans are generally not considered taxable income as long as the life insurance policy remains in force. The Internal Revenue Service (IRS) views these transactions as loans, not distributions of income. However, if the policy lapses or is surrendered with an outstanding loan balance, the amount of the loan, up to the amount of gain in the policy, can become taxable income. This conversion from a tax-free loan to a taxable distribution occurs because the loan is no longer collateralized by an active policy.

Cash withdrawals are generally tax-free up to the amount of the policyholder’s cost basis, which is the total premiums paid into the policy. This is often referred to as the “return of premium” and is not considered a taxable event. Any amount withdrawn that exceeds the cost basis is considered a taxable gain and is subject to ordinary income tax rates. This “gain” represents the earnings on the cash value beyond the premiums paid.

When a policy is surrendered, if the cash surrender value received is greater than the total premiums paid into the policy (the 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 a policyholder paid $50,000 in premiums and received $60,000 upon surrender, the $10,000 gain would be taxable.

It is important to consider the Modified Endowment Contract (MEC) rules, which can alter the tax treatment of policy loans and withdrawals. A life insurance policy becomes a MEC if it fails the “7-pay test,” meaning that premiums paid during the first seven years exceed a certain limit set by the IRS. If a policy is classified as a MEC, loans and withdrawals are subject to “last-in, first-out” (LIFO) taxation, meaning that earnings are considered to be withdrawn first and are therefore immediately taxable. Additionally, withdrawals and loans from a MEC before the policyholder reaches age 59½ may be subject to a 10% federal penalty tax on the taxable portion of the distribution, similar to early withdrawals from retirement accounts.

Alternative Ways to Access Funds

Beyond directly accessing a policy’s cash value, policyholders can explore other avenues to obtain funds from their life insurance under specific circumstances. These alternatives typically involve accessing a portion of the death benefit or selling the policy itself. Each option serves different needs and carries its own set of considerations.

Accelerated death benefits, also known as living benefits riders, allow policyholders to access a portion of their policy’s death benefit while still alive. These riders are triggered by specific qualifying events, such as a diagnosis of a terminal illness with a limited life expectancy, a chronic illness requiring permanent care, or a critical illness like a heart attack or stroke. The funds received reduce the eventual death benefit paid to beneficiaries. The tax treatment is generally favorable, often being tax-free if used for qualified expenses, particularly in cases of terminal or chronic illness. To utilize this, policyholders must meet the specific criteria outlined in their policy’s rider.

A life settlement involves selling an existing life insurance policy to a third-party investor for a lump sum. This amount is typically greater than the policy’s cash surrender value but less than the full death benefit. Policyholders often consider this option when they no longer need coverage, cannot afford premiums, or require immediate financial liquidity. The process involves an appraisal, an offer, and the transfer of ownership to the investor, who then assumes responsibility for future premiums and receives the death benefit. Proceeds may be subject to income tax, particularly on any amount exceeding the policy’s cost basis.