Can Term Life Insurance Be Cashed Out?
Clarify common misconceptions about term life insurance. Understand its design as pure protection and how it differs from policies with cash value.
Term life insurance does not build cash value, meaning it generally cannot be “cashed out” in the way some other life insurance policies can. This type of insurance is designed to provide coverage for a specific period of time, known as the “term.” If the insured individual passes away within this defined term, a death benefit is paid to the beneficiaries. Term life insurance serves as pure financial protection for a set duration.
Understanding Term Life Insurance and Cash Value
Term life insurance is a contract providing a death benefit for a fixed period, typically ranging from 10 to 30 years. The premiums for a level term policy remain consistent throughout the chosen term. This type of policy is generally more affordable than permanent life insurance because it focuses solely on providing a death benefit. The premiums paid cover the cost of the death benefit coverage and the administrative expenses of the insurance company.
Unlike other forms of life insurance, term life policies do not have an investment or savings component, meaning premiums are not allocated to an accumulating fund. This is why term life insurance cannot be “cashed out” by the policyholder. It functions much like auto or homeowner’s insurance, where premiums pay for protection over a period, and there is no return if no claim is made.
Cash value refers to an accumulated savings component within a policy that can be accessed by the policyholder during their lifetime. This value typically grows on a tax-deferred basis. Term life insurance provides temporary financial security, suitable for covering specific financial obligations that will eventually end, such as a mortgage or the period a child is dependent.
What Happens When a Term Policy Ends or Is Canceled
When a term life insurance policy reaches the end of its specified term, the coverage simply ceases. There is no payout or refund of premiums, unless a specific rider, such as a return-of-premium rider, was purchased, which typically makes the premiums significantly higher. If the policyholder still requires coverage after the term expires, they may have options to renew the policy or convert it to a permanent life insurance policy.
Renewing a term policy usually involves substantially higher premiums, as the cost of insurance increases with age and potential health changes. While some policies offer guaranteed renewability, allowing extension without a new medical exam, the rising cost can make it financially impractical over time.
If a term life insurance policy is canceled prematurely by the policyholder, there is generally no refund of the premiums paid. The premiums cover the period of coverage that was in force, similar to how auto insurance premiums cover a period even if no accident occurs. Some exceptions might include a full refund if canceled within a short “free look” period, typically 10 to 30 days after policy issuance.
Life Insurance Policies with Cash Value Features
Certain types of permanent life insurance policies include a cash value component that accumulates over time. Whole life insurance, for instance, offers lifelong coverage with a guaranteed cash value growth rate. A portion of each premium payment contributes to this cash value, which grows on a tax-deferred basis.
Universal life insurance is another type of permanent policy that builds cash value, offering more flexibility than whole life in terms of premium payments and death benefit adjustments. The cash value in universal life policies typically grows based on an interest rate set by the insurer, and some variations like indexed universal life or variable universal life link cash value growth to market indices or investment performance, respectively. These policies allow for potential higher returns but may also carry greater risk.
Policyholders can access the accumulated cash value in several ways. One common method is through a policy loan, where the cash value serves as collateral. These loans are generally not considered taxable income, provided the policy remains in force and is not classified as a Modified Endowment Contract (MEC). Another option is to make withdrawals from the cash value; withdrawals up to the amount of premiums paid into the policy are typically tax-free, but any amount exceeding this cost basis may be taxed as ordinary income.
Alternatively, a policyholder can surrender the entire policy for its cash surrender value, which is the cash value minus any applicable surrender charges or outstanding loans. When surrendering a policy, any amount received that exceeds the total premiums paid is considered taxable income and is taxed at ordinary income rates. Due to these features and the lifelong nature of coverage, permanent life insurance policies generally have significantly higher premiums compared to term life insurance.