Can You Cash In Your Life Insurance Policy?

“Cashing in” a life insurance policy means accessing its accumulated financial value while the policyholder is alive. This applies to policies that build a cash component over time, allowing policyholders to tap into this value before the death benefit is paid out.

Understanding Policies with Cash Value

Permanent life insurance policies accumulate cash value, which grows over the policy’s lifetime. This cash value offers a living benefit in addition to the death benefit. Primary types include Whole Life, Universal Life, and Variable Universal Life policies.

Whole life insurance features a guaranteed death benefit and a cash value component that grows at a guaranteed interest rate. A portion of each premium payment contributes to this cash value, which accumulates steadily over time.

Universal life insurance offers more flexibility, allowing adjustments to premium payments and death benefits, and its cash value typically grows based on an interest rate set by the insurer or tied to an external index.

Variable universal life insurance allows policyholders to invest the cash value in various sub-accounts, similar to mutual funds. This offers potential for higher growth but also carries investment risk, meaning the cash value can fluctuate with market performance.

In contrast, term life insurance, which provides coverage for a specific period, generally does not build cash value and therefore cannot be “cashed in” in the same manner.

Direct Access Options from Your Insurer

Policyholders with cash value life insurance can access funds directly from their insurer. Each method has distinct implications for the policy’s future and its death benefit.

Policy Loans

One common method is taking a policy loan, where the insurer lends money using the policy’s cash value as collateral. These loans typically do not require a credit check and often have flexible repayment terms, without a fixed schedule. Interest accrues on the loan balance, and if this interest is not paid, it can be added to the outstanding loan amount.

An outstanding loan balance will reduce the death benefit paid to beneficiaries if the insured passes away before the loan is fully repaid. If the loan plus accrued interest grows to exceed the policy’s cash value, the policy could lapse, leading to potential tax consequences on the outstanding loan amount. Policyholders can typically borrow up to around 90% of the current cash value.

Cash Value Withdrawals

Policyholders can also make direct withdrawals from the accumulated cash value. Unlike loans, withdrawals permanently reduce the policy’s cash value and, consequently, the death benefit. While some policies may allow unlimited withdrawals, others might have limits on the frequency or amount that can be taken.

Withdrawals are generally tax-free up to the amount of premiums paid into the policy, which is considered a return of cost basis. However, any amount withdrawn that exceeds this cost basis is typically taxable as ordinary income. Excessive withdrawals can deplete the cash value, potentially leading to the policy lapsing if it can no longer support its own charges or future premiums.

Policy Surrender

Completely surrendering a life insurance policy involves canceling the contract in exchange for its net cash surrender value. This action terminates the policy, meaning all coverage ceases and no death benefit will be paid to beneficiaries upon the insured’s passing. The cash surrender value is calculated as the accumulated cash value minus any outstanding loans, unpaid interest, and applicable surrender charges.

Surrender charges are fees imposed by the insurance company for terminating the policy early, especially within the first 10 to 15 years. These charges can significantly reduce the amount received and typically decrease over time, often disappearing after a certain period. Surrendering a policy can result in a financial loss if the surrender value is less than the total premiums paid.

Selling Your Policy to a Third Party

An alternative to direct access through the insurer is selling the life insurance policy to a third-party investor, a transaction known as a life settlement. This option provides a lump sum payment that is typically greater than the policy’s cash surrender value but less than its full death benefit. The buyer assumes responsibility for future premium payments and receives the death benefit when the insured dies.

A specific type of life settlement is a viatical settlement, which applies when the policyholder is terminally or chronically ill, generally with a life expectancy of two years or less. Viatical settlements offer individuals facing severe health challenges a way to access funds for medical expenses or other needs. Both life and viatical settlements involve transferring ownership of the policy to an investor.

General eligibility criteria for a life settlement often include the insured being at least 65 years old and the policy having a death benefit of $100,000 or more. Health status is a significant factor, with individuals having serious health impairments or shorter life expectancies more likely to qualify. Policies must typically have been in force for at least two years, though some states may require a longer period, such as five years.

The process often involves working with a life settlement broker who represents the seller and solicits offers from various state-licensed providers.

Financial Implications of Accessing Policy Value

Accessing a life insurance policy’s value, whether through loans, withdrawals, surrender, or sale, carries distinct financial and tax consequences.

Taxation

The tax treatment of funds accessed from a life insurance policy varies significantly by method. Policy loans are generally not considered taxable income because they are treated as a debt against the policy’s cash value. However, if a policy lapses or is surrendered with an outstanding loan, the loan amount exceeding the premiums paid could become taxable.

Cash value withdrawals are typically tax-free up to the policyholder’s cost basis, which is the total amount of premiums paid into the policy. Any amount received above this cost basis is usually taxed as ordinary income. A crucial consideration is the “modified endowment contract” (MEC) designation. If a policy fails the IRS’s 7-pay test, meaning too much premium was paid into it too quickly, it becomes an MEC. Distributions from an MEC, including loans and withdrawals, are taxed on a “last-in, first-out” (LIFO) basis, meaning gains are taxed first as ordinary income, and withdrawals before age 59½ may incur an additional 10% penalty.

When surrendering a policy, any gain—the cash surrender value minus the premiums paid—is taxable as ordinary income. For life settlements, taxation is tiered: proceeds up to the cost basis are tax-free, amounts above the cost basis up to the cash surrender value are taxed as ordinary income, and any remaining proceeds are taxed as capital gains. Viatical settlements, specifically for the terminally or chronically ill, are generally considered tax-free.

Impact on Death Benefit

Each method of accessing policy value can reduce or eliminate the death benefit payable to beneficiaries. Policy loans, if not repaid, directly reduce the death benefit by the outstanding loan amount plus accrued interest. Cash value withdrawals also permanently decrease the death benefit, often dollar-for-dollar with the amount withdrawn.

Surrendering a policy completely eliminates the death benefit, as the policy is terminated. In a life settlement, the policy is sold to a third party, meaning the original beneficiaries will receive no death benefit from that specific policy, as the new owner becomes the beneficiary.

Surrender Charges and Policy Lapse Risk

Surrender charges are fees applied if a policy is terminated or funds are withdrawn during an initial period, typically the first 10 to 15 years. These charges can be substantial, sometimes 10% to 40% of the cash value, and reduce the net amount received. They are designed to recoup the insurer’s upfront costs associated with issuing the policy.

Accessing policy value can increase the risk of policy lapse. If excessive withdrawals are made or policy loans are left unpaid, the cash value may deplete to a point where it can no longer cover the policy’s ongoing charges and premiums. When this occurs, the policy may terminate, potentially leading to unforeseen tax liabilities on outstanding loans and a complete loss of coverage.