Can You Cash Out a Life Insurance Policy?

Life insurance policies provide financial protection, and some offer a cash value component accessible during the policyholder’s lifetime. This feature allows individuals to tap into their policy’s accumulated funds for various needs. Not all policies include cash value, so understanding which types offer this benefit and how it functions is important.

Understanding Life Insurance Cash Value

Cash value in life insurance is a savings component within certain policies. It builds over time as a portion of each premium payment is allocated to this fund, which typically grows on a tax-deferred basis. This accumulated cash can become a financial asset for the policyholder.

Permanent life insurance policies, such as whole life, universal life, variable universal life, and indexed universal life, are designed to build cash value. These policies offer lifelong coverage, and their cash value accumulates over the years. In contrast, term life insurance policies do not build cash value; they provide temporary protection for a specific period without a savings component.

Ways to Access Your Policy’s Cash Value

Policyholders with permanent life insurance have several methods to access accumulated cash value. One option is a policy surrender, which terminates coverage entirely. When surrendered, the policyholder receives the cash surrender value, which is the accumulated cash value minus any applicable surrender charges.

Another common method is taking a policy loan, where the policyholder borrows money directly from the insurer, using the cash value as collateral. These loans accrue interest but generally do not require repayment on a strict schedule. Any outstanding loan balance, including accrued interest, will reduce the death benefit paid to beneficiaries if the loan is not repaid before the policyholder’s passing.

Partial withdrawals represent a third way to access cash value, available in some policy types like universal life insurance. Unlike loans, withdrawals do not need to be repaid and directly reduce the policy’s cash value and death benefit on a dollar-for-dollar basis. While withdrawals provide immediate access to funds, they are permanent reductions to the policy’s value.

Tax and Financial Considerations

Accessing life insurance cash value has specific tax and financial implications. The growth of cash value within a policy is tax-deferred, meaning taxes are not typically owed as the value accumulates. However, taxes may apply when funds are withdrawn or the policy is surrendered. If the amount received exceeds the total premiums paid into the policy, this excess is considered a taxable gain and is taxed as ordinary income. The total premiums paid represent the policyholder’s “cost basis.”

Policy loans are generally not considered taxable income as long as the policy remains in force. However, if a policy lapses or is surrendered with an outstanding loan, the loan amount, to the extent it exceeds the cost basis, can become taxable income. Policies classified as Modified Endowment Contracts (MECs) have different tax rules, where withdrawals and loans are taxed on a “last in, first out” (LIFO) basis, meaning earnings are taxed first, and may be subject to a 10% penalty if the policyholder is under age 59½.

Accessing cash value directly impacts the death benefit. Policy surrenders eliminate the death benefit entirely, while partial withdrawals and outstanding policy loans reduce the death benefit amount. This reduction can affect the financial protection intended for beneficiaries. Large withdrawals or unpaid loans can deplete the cash value, increasing the risk of the policy lapsing if there are insufficient funds to cover ongoing policy charges.

Other Options for Unneeded Policies

For policyholders who no longer need their permanent life insurance policy, several alternatives to direct surrender exist.

Life Settlement

A life settlement involves selling the policy to a third party for a cash payment. This payment is typically more than the cash surrender value but less than the full death benefit. The new owner assumes responsibility for future premiums and receives the death benefit upon the insured’s passing.

Accelerated Death Benefit (ADB) Riders

ADB riders allow policyholders to access a portion of their death benefit while still alive, usually under specific conditions such as a terminal or chronic illness diagnosis. This can provide funds for medical expenses or other needs, although the death benefit paid to beneficiaries will be reduced. Many ADB riders are included automatically in policies at no additional cost.

Non-Forfeiture Options

The reduced paid-up option, available in some permanent policies, allows the policyholder to stop paying premiums. The existing cash value is used to purchase a smaller, fully paid-up policy with a reduced death benefit. Similarly, the extended term option uses the accumulated cash value to purchase a term life insurance policy for a specified period, maintaining the original death benefit amount for that term without further premium payments.

Charitable Donation

Policyholders may also consider donating their life insurance policy to a charity, either by transferring ownership or naming the charity as a beneficiary, potentially offering tax benefits.