Can You Cash In Life Insurance Policies?

Life insurance serves as a financial protection tool, providing a death benefit to beneficiaries upon the insured’s passing. While term life insurance offers coverage for a specific period without accumulating value, certain permanent life insurance policies include a savings component known as cash value. This cash value grows over time and can be accessed by the policyholder during their lifetime. Understanding this cash value is important for policyholders.

Types of Policies with Cash Value

Permanent life insurance policies are designed to provide coverage for an individual’s entire life, and they typically feature a cash value component. A portion of each premium paid into these policies is allocated to the cash value account, which then grows over time. This accumulated cash value differs from the death benefit, which is the amount paid to beneficiaries. The growth of this cash value is tax-deferred, meaning taxes are not paid until funds are withdrawn.

Whole life insurance is a common type of permanent policy where the cash value grows at a guaranteed interest rate. Premiums for whole life policies are fixed, and the cash value accumulation is predictable. This policy provides lifelong coverage as long as premiums are paid, and cash value increases through guaranteed interest and potential dividends.

Universal life (UL) insurance offers more flexibility than whole life, allowing policyholders to adjust premium payments and death benefits. The cash value in a UL policy grows based on an interest rate set by the insurer, often with a guaranteed minimum rate. This flexibility can be useful for managing financial changes.

Variable universal life (VUL) insurance policies combine the flexibility of universal life with investment options. The cash value in a VUL policy is invested in subaccounts, similar to mutual funds, chosen by the policyholder. This offers potential for higher returns, but also carries investment risk, as cash value and death benefit can fluctuate based on market performance.

Ways to Access Policy Cash Value

Policyholders have several methods to access the accumulated cash value within their permanent life insurance policies. These options allow for liquidity but also carry specific implications for the policy and its death benefit. It is advisable to wait several years for sufficient cash value to accumulate.

One method is a policy surrender, which involves terminating the life insurance contract entirely. Upon surrender, the policyholder receives the cash surrender value, which is the accumulated cash value minus any applicable surrender charges or outstanding loans. This action immediately ends the life insurance coverage and the death benefit. Surrender charges, if any, apply during the early years and can reduce the amount received.

Policy loans allow a policyholder to borrow money from the insurer, using the policy’s cash value as collateral. There is no credit check or lengthy approval process for these loans, as the policy itself secures the debt. Policyholders can borrow up to 90% of their policy’s cash value. Interest accrues on the loan, and if the loan and interest are not repaid, the outstanding balance reduces the death benefit paid to beneficiaries.

Another way to access cash value is through a partial withdrawal. Some permanent policies permit direct withdrawals from the cash value. Unlike a loan, withdrawals permanently reduce the policy’s cash value and the death benefit. The amount withdrawn is not repaid, and it directly diminishes the funds available within the policy.

Understanding the Financial Impact

Accessing cash value from a life insurance policy carries various financial implications, including tax consequences, effects on the death benefit, and potential for policy lapse. Understanding these factors is important before making any decisions. The tax treatment of cash value access depends on the method used and the policy’s characteristics.

When a policy is surrendered, any amount received exceeding the “cost basis” is taxed as ordinary income. The cost basis refers to the total premiums paid into the policy, less any prior withdrawals. For example, if a policyholder paid $50,000 in premiums and surrenders the policy for $60,000, the $10,000 gain would be taxable income. Partial withdrawals are tax-free up to the cost basis, but amounts exceeding the basis are taxed as ordinary income.

Policy loans are tax-free, as they are considered borrowing against an asset rather than a distribution of earnings. However, if a policy lapses with an outstanding loan balance that exceeds the policy’s cost basis, the amount of the loan that represents gains can become taxable income. This can also trigger a 10% IRS penalty if the policy is a Modified Endowment Contract (MEC) and the policyholder is under age 59½. MECs have special tax rules, treating withdrawals and loans on a “last-in, first-out” basis, meaning earnings are considered distributed first and are taxable, potentially with a 10% penalty if taken before age 59½.

Any outstanding policy loan, including accrued interest, will directly reduce the death benefit paid to beneficiaries if not repaid before the insured’s passing. Similarly, partial withdrawals directly decrease both the cash value and the death benefit. If the cash value is significantly reduced through loans or withdrawals and becomes insufficient to cover policy charges and premiums, the policy can lapse, leading to a loss of coverage.

Other Options for Your Policy

Policyholders have alternative strategies for leveraging their life insurance or discontinuing premium payments. These options can provide financial relief or re-purpose the policy without a full surrender.

Viatical settlements allow terminally or chronically ill policyholders to sell their life insurance policy to a third party for a lump sum. This option is available to individuals with a life expectancy of two years or less. The payout is higher than the policy’s cash surrender value but less than the full death benefit. Proceeds are not subject to federal income tax.

Accelerated Death Benefits, also known as living benefits, are riders that allow policyholders to access a portion of their death benefit while still alive, usually under specific circumstances like a terminal, chronic, or critical illness diagnosis. The funds can help cover medical expenses or other needs, and the remaining death benefit is paid to beneficiaries upon the insured’s passing.

Life settlements involve selling a life insurance policy to a third-party investor, when the policyholder is older but not necessarily terminally ill. This option is pursued by individuals aged 65 or older who no longer need or can afford their policy. The payout is greater than the cash surrender value but less than the death benefit. Unlike viatical settlements, life settlement proceeds may be subject to taxation, with portions taxed as ordinary income or capital gains.

For policyholders who wish to stop paying premiums but retain some coverage, the Reduced Paid-Up option is available. This non-forfeiture option converts the existing policy into a smaller, fully paid-up policy, meaning no further premiums are due. The death benefit is reduced proportionally to premiums already paid and accumulated cash value.

Another non-forfeiture option is Extended Term insurance, where the policy’s cash value is used to purchase a new term life policy for a specified duration. The new term policy retains the same death benefit as the original permanent policy. This option provides continued coverage for a limited period without additional premium payments, using accumulated cash value to fund the new term.