Can You Cash Out a Life Insurance Policy?

Life insurance offers financial protection to beneficiaries upon the policyholder’s passing. Beyond this core function, certain life insurance policies incorporate a “cash value” component. This feature allows policyholders to accumulate funds that can be accessed during their lifetime through various options, from loans to policy liquidation. Understanding these policies and the implications of accessing their value is important for anyone considering such an option.

Types of Policies with Cash Value

Cash value in a life insurance policy is a portion of premiums that accumulates over time in a separate account. This value grows tax-deferred, meaning earnings are not taxed until withdrawn. Growth mechanisms vary by policy type, but generally include a savings or investment component.

Life insurance policies are categorized as term life or permanent life. Term life insurance covers a specific period, like 10, 20, or 30 years, and typically does not build cash value. Therefore, term policies generally cannot be cashed out.

Permanent life insurance policies provide lifelong coverage and build cash value. Whole life insurance, a common permanent policy, features a guaranteed cash value that grows at a fixed, predictable rate, unaffected by market fluctuations.

Universal life (UL) insurance also accumulates cash value, offering flexibility in premiums and death benefits. Its cash value grows based on insurer-set interest rates or market performance, often with a guaranteed minimum.

Variable universal life (VUL) insurance allows investment of cash value in market options like equities or index funds. VUL cash value growth depends directly on underlying investment performance, introducing higher potential returns and increased risk.

Indexed universal life (IUL) insurance ties cash value growth to a stock market index, such as the S&P 500. These policies often include a floor and cap on returns to balance risk and reward.

Ways to Access Cash Value

Policyholders can access their permanent life insurance policy’s accumulated cash value through several methods, each with distinct procedures and outcomes.

Policy surrender involves terminating the life insurance coverage entirely. The policyholder receives the cash surrender value, which is the accumulated cash value minus any surrender charges or outstanding loans. Surrender charges can be significant, especially in the early years, potentially lasting 10 to 15 years. This action ends insurance coverage, meaning no death benefit will be paid to beneficiaries.

Policy loans allow borrowing directly from the insurer, using the policy’s cash value as collateral. The loan comes from the insurance company’s general account, and the policy remains in force. Interest accrues, and any unpaid loan balance, including interest, reduces the death benefit. If the outstanding loan balance plus interest exceeds the cash value, the policy could lapse, leading to a loss of coverage.

Some permanent policies, especially Universal Life, permit partial withdrawals from the cash value. A withdrawal removes a portion of the cash value directly from the policy, reducing both the remaining cash value and the death benefit proportionally. Unlike a loan, withdrawn funds do not need repayment, but they permanently decrease the policy’s value and beneficiary benefit.

A life settlement involves selling an existing life insurance policy to a third party. The policyholder receives a lump sum cash payment, typically more than the cash surrender value but less than the full death benefit. The buyer becomes the new owner, assumes future premium payments, and receives the death benefit. This option is often considered by older policyholders or those with changed coverage needs.

Tax Implications of Accessing Cash Value

Accessing a life insurance policy’s cash value can have various tax consequences, depending on the access method and policy characteristics.

The “cost basis” refers to the total premiums paid into the policy. When surrendering or withdrawing, amounts received up to the cost basis are generally tax-free as a return of principal. Any amount above the cost basis, representing policy gain, is usually subject to ordinary income tax.

Policy loans are generally not taxable income as long as the policy remains in force. However, if the policy lapses or is surrendered with an outstanding loan, the loan amount exceeding premiums paid can become taxable income. This can create an unexpected tax liability, sometimes called “phantom income.”

Life settlement proceeds have more complex tax treatment. Amounts received up to the cost basis are generally tax-free. Any amount between the cost basis and the cash surrender value is typically taxed as ordinary income. Proceeds above the cash surrender value are usually taxed as capital gains.

A Modified Endowment Contract (MEC) is a life insurance policy funded too quickly, exceeding IRS limits. If classified as an MEC, withdrawals and loans face less favorable tax rules. They are taxed on a “last-in, first-out” (LIFO) basis, meaning gains are withdrawn first and subject to ordinary income tax. If the policyholder is under age 59½, these taxable amounts may also incur a 10% penalty, similar to early retirement withdrawals. Consulting a tax professional is advisable for personalized guidance.

Consequences of Accessing Cash Value

Accessing a life insurance policy’s cash value has direct consequences for the policy and its intended purpose. Understanding these impacts is important before making decisions.

Surrendering a life insurance policy results in complete termination of coverage. The death benefit, a primary reason for purchase, will no longer be available to beneficiaries. For partial withdrawals or outstanding policy loans, the death benefit reduces by the amount withdrawn or the outstanding loan balance plus accrued interest. This reduction impacts beneficiaries’ financial security.

Excessive withdrawals or unrepaid policy loans can lead to a policy lapse. If the remaining cash value becomes insufficient to cover ongoing charges and premiums, the policy may terminate. A lapsed policy means losing insurance coverage, including the death benefit. This outcome defeats the objective of long-term financial protection.

Accessing cash value fundamentally alters or ends the original insurance coverage. The policy’s primary role of providing a death benefit to beneficiaries is compromised or eliminated. While accessing cash value provides immediate liquidity, it does not eliminate the need for ongoing premium payments unless the policy is fully surrendered or paid-up. Continued premium payments are required to keep the policy in force and prevent further erosion of its value or coverage.