Can I Take Out My Life Insurance Money?

Life insurance primarily provides a death benefit to beneficiaries upon the policyholder’s passing. However, certain types of life insurance policies offer financial flexibility beyond this traditional purpose. These policies can accumulate value over time, which policyholders may access during their lifetime. This accessible value provides a resource for various financial needs, offering a living benefit in addition to the eventual death benefit. Understanding how to access these funds and their implications is important for policyholders.

Types of Life Insurance with Accessible Funds

Life insurance policies that allow access to funds during the policyholder’s lifetime are known as permanent life insurance, characterized by a component called “cash value.” This cash value is a portion of the premiums paid that grows over time on a tax-deferred basis, functioning as a savings or investment element within the policy. This accumulation differentiates permanent policies from term life insurance, which provides coverage for a specific period and does not build cash value.

Whole life insurance is a type of permanent policy where the cash value grows at a guaranteed rate, and premiums remain fixed throughout the policy’s life. This predictability provides a stable accumulation of value, often enhanced by potential dividends from the insurer. Universal life insurance offers more flexibility in premiums and death benefits, with its cash value growth tied to interest rates that may have a guaranteed minimum or be linked to market performance. This structure allows policyholders to adjust payments based on their financial circumstances, though excessive flexibility can impact cash value growth.

Variable universal life insurance combines the features of universal life with an investment component. A portion of the cash value can be allocated to various sub-accounts, similar to mutual funds, offering the potential for higher returns but also carrying investment risk. This type of policy provides control over investment choices and premium payments. The growth of cash value in these policies is tax-deferred, meaning taxes on earnings are postponed until funds are withdrawn.

Ways to Access Policy Funds

Policyholders can access the accumulated cash value in their permanent life insurance policies through several mechanisms. Each method has distinct characteristics regarding how funds are obtained and their impact on the policy. These methods include taking out a policy loan, making a cash withdrawal or partial surrender, or fully surrendering the policy.

Taking a policy loan involves borrowing money from the insurer, using the policy’s cash value as collateral. This process does not require a credit check or formal application, and funds can be received within days. Policy loans offer flexible repayment terms, meaning there is no strict repayment schedule, and policyholders can choose to repay the loan at their own pace or not at all.

Interest rates on these loans generally range from 5% to 8%. The cash value within the policy continues to earn interest or dividends even while a loan is outstanding, though interest accrues on the loan balance. Policyholders can borrow up to 90% of their accumulated cash value.

A cash withdrawal, also referred to as a partial surrender, allows the policyholder to directly remove a portion of the cash value from the policy. Unlike a loan, a withdrawal is a permanent reduction of the policy’s cash value and does not need to be repaid. This action can subsequently decrease the death benefit available to beneficiaries. While withdrawals provide immediate access to funds, they are irreversible, and the withdrawn amount cannot be redeposited into the policy.

Policy surrender involves terminating the entire life insurance policy in exchange for its cash surrender value. The cash surrender value is calculated as the policy’s accumulated cash value minus any applicable surrender charges or outstanding loans. Surrender charges are higher in the initial years of the policy and decrease over time. Upon full surrender, the policy ceases to exist, eliminating the death benefit.

Tax Considerations of Accessing Funds

Accessing funds from a life insurance policy involves specific tax implications that vary depending on the method used. The cash value within permanent life insurance policies grows on a tax-deferred basis. A key concept in determining tax liability is the “cost basis,” which refers to the total amount of premiums paid into the policy.

Policy loans are typically not considered taxable income as long as the policy remains in force. This is because a loan is viewed as borrowing against an asset, not as a distribution of income. However, if the policy lapses or is surrendered with an outstanding loan, the loan amount exceeding the policy’s cost basis may become taxable income. The interest accrued on a policy loan is generally not tax-deductible.

Cash withdrawals are treated as a return of premium up to the policy’s cost basis and are therefore tax-free to that extent. Any amount withdrawn that exceeds the cost basis is considered a gain and is taxed as ordinary income.

When a policy is fully surrendered, the difference between the cash surrender value received and the total premiums paid (cost basis) is considered a taxable gain. This gain is taxed as ordinary income, not capital gains. Surrender charges reduce the payout received, but the tax calculation is still based on the gain over the cost basis.

A tax consideration arises if a policy is classified as a Modified Endowment Contract (MEC). A policy becomes a MEC if the premiums paid during its first seven years exceed specific IRS limits. Once designated as a MEC, this status is irreversible, and the tax treatment of distributions changes. Withdrawals and loans from a MEC are taxed on a “last-in, first-out” (LIFO) basis, meaning any gains are considered withdrawn first and are immediately taxable as ordinary income. Additionally, withdrawals or loans from a MEC taken before age 59½ may incur a 10% IRS penalty.

Effects on Policy and Beneficiaries

Accessing funds from a life insurance policy affects the policy’s viability and the financial protection intended for beneficiaries. These actions can reduce the death benefit. Understanding these effects is crucial before utilizing policy funds.

An outstanding policy loan and any accrued interest will be deducted from the death benefit paid to beneficiaries if the insured dies before the loan is fully repaid. Beneficiaries will receive a reduced payout. If the total loan balance, including interest, grows to exceed the policy’s cash value, the policy can lapse. Policy lapse results in the termination of coverage.

Cash withdrawals permanently reduce the policy’s cash value. This reduction decreases the policy’s death benefit. Since withdrawals are not repaid, the reduction in the death benefit is permanent. The long-term impact on the policy’s value and death benefit requires careful evaluation.

Surrendering a life insurance policy eliminates the death benefit. Upon surrender, the policy ceases to exist. This decision means forfeiting the primary purpose of life insurance, which is to provide financial protection to dependents. Policy surrender irrevocably ends coverage.