Can I Withdraw Money From Life Insurance?

Life insurance primarily provides a death benefit to beneficiaries upon the policyholder’s passing. However, certain types of life insurance policies also offer a cash value component that can be accessed during the policyholder’s lifetime. This cash value can become a source of funds for various financial needs. Only permanent life insurance policies build this accessible cash value; term life insurance does not.

Understanding Cash Value in Life Insurance

Cash value is a component within permanent life insurance policies, including whole life, universal life, variable life, and indexed universal life. This cash value grows separately from the death benefit. A portion of each premium payment is allocated to this account, with the remainder covering insurance costs and insurer expenses.

Cash value accumulates over time, often at a guaranteed interest rate in whole life policies, or at a market-dependent rate with a minimum guarantee in universal life policies. This growth is tax-deferred, meaning earnings are not taxed as they accumulate within the policy. In the initial years, a larger percentage of the premium may be directed towards the cash value. Term life insurance policies do not build any cash value that can be accessed.

Accessing Your Policy’s Cash Value Through Loans

One method of accessing the accumulated cash value in a permanent life insurance policy is by taking a policy loan. This is borrowing money from the insurance company, using your policy’s cash value as collateral, rather than withdrawing your own funds. Policy loans do not require a credit check or a lengthy application process. The loan amount is typically limited to a high percentage of the cash value, often up to 90% or 95%.

Policy loans offer flexible repayment terms, with no strict schedule or requirement for regular payments. Policyholders can choose to repay the loan over time, pay only the interest, or not repay the principal at all. Interest accrues on the outstanding loan balance, with rates typically ranging from 5% to 9%. If the loan and its accrued interest are not repaid, the outstanding balance will reduce the death benefit paid to beneficiaries. If the loan balance plus interest grows to exceed the policy’s cash value, the policy can lapse, potentially leading to the loss of coverage.

Accessing Your Policy’s Cash Value Through Withdrawals and Surrender

Partial Withdrawals

Beyond loans, policyholders can access their cash value through partial withdrawals. A partial withdrawal involves directly removing funds from the policy’s cash value. This action permanently reduces the cash value and typically results in a corresponding decrease in the policy’s death benefit. Unlike a loan, a withdrawal is not a debt that needs to be repaid; it is a permanent reduction of the policy’s value.

Some policies, particularly universal life policies, may allow partial withdrawals. There can be limits on the amount or frequency of withdrawals, with some insurers restricting withdrawals to a percentage of the fund value, such as 10% to 20% in a policy year. Partial withdrawals might also be subject to a lock-in period, such as five years, before they are permitted. While withdrawals provide direct access to funds, they can diminish the policy’s protective features and long-term accumulation potential.

Policy Surrender

Surrendering a life insurance policy means terminating the contract entirely. When a policy is surrendered, the policyholder receives its “cash surrender value.” This value is generally the accumulated cash value minus any applicable fees or outstanding loans. Surrender charges, which can be significant, are often applied if the policy is terminated within a certain period, commonly 10 to 20 years from its inception.

Surrendering the policy leads to the complete cessation of life insurance coverage, meaning the death benefit is no longer available to beneficiaries. The calculation of the surrender value can vary by insurer but typically involves deducting fees from the current cash value. This option provides access to a larger sum of money than a partial withdrawal but comes at the cost of losing all future insurance protection.

Tax Consequences of Accessing Life Insurance Funds

Policy Loans and MECs

Accessing funds from life insurance policies carries specific tax implications. Policy loans are generally not considered taxable income as long as the policy remains in force. This is because the loan is treated as a debt against the policy’s value, not a distribution of earnings. However, if a policy lapses or is surrendered with an outstanding loan, the loan amount, to the extent it exceeds the policyholder’s cost basis, can become taxable as ordinary income.

A crucial exception to the tax-free treatment of policy loans and withdrawals arises if the life insurance policy is classified as a Modified Endowment Contract (MEC). A policy becomes a MEC if premiums paid exceed certain IRS limits, typically determined by a “7-pay test” during the first seven years. For MECs, loans and withdrawals are taxed on a Last-In, First-Out (LIFO) basis, meaning any earnings are considered to be withdrawn first and are immediately taxable as ordinary income. Additionally, if the policyholder is under age 59½, a 10% penalty tax may apply to the taxable portion of the distribution from a MEC.

Withdrawals and Surrenders

For partial withdrawals from non-MEC policies, the amounts are generally tax-free up to the policyholder’s “cost basis.” The cost basis in a life insurance policy primarily represents the total premiums paid into the policy, minus any prior dividends received or withdrawals. Withdrawals exceeding this cost basis are typically taxed as ordinary income. This “first-in, first-out” (FIFO) rule for non-MECs means that the return of premiums (basis) is considered to occur before any taxable gains.

When a policy is surrendered, any amount received above the policyholder’s cost basis is considered taxable income. This gain is typically taxed at ordinary income rates, not capital gains rates. The cash surrender value received is calculated after deducting any fees, and the taxable portion is the difference between this net amount and the premiums paid.