Can You Cash Out a Life Insurance Policy Before You Die?

Life insurance policies provide financial protection to beneficiaries after the insured passes away. However, certain types of life insurance also offer access to funds while the policyholder is still living. Accessing value from a life insurance policy during your lifetime is often possible, depending on the specific policy type and structure.

Understanding Life Insurance Cash Value

Cash value in life insurance is a savings component that accumulates within permanent policies. This value grows over time and can be a source of funds. A portion of each premium payment is allocated to this cash account, where it typically earns interest on a tax-deferred basis.

Permanent life insurance policies (whole life, universal life, variable universal life, and indexed universal life) build cash value. Whole life policies usually feature a guaranteed growth rate. Universal life policies may have growth tied to market interest rates or investment performance, often with a minimum guarantee. Variable universal life policies allow the policyholder to invest cash value in market-based sub-accounts, offering higher potential returns but also more risk.

Cash value is distinct from the death benefit paid to beneficiaries upon the insured’s death. Term life insurance policies do not build cash value because they provide coverage only for a specific period and do not have a savings component.

Direct Access Methods from the Insurer

Accessing funds directly from the insurer involves specific actions utilizing accumulated cash value within a permanent life insurance policy. These methods impact the policy’s cash value and death benefit.

Policy Loans

Policy loans allow borrowing money using the policy’s cash value as collateral. The loan is from the insurer, secured by the cash value. Loans accrue interest, and any outstanding balance will reduce the death benefit if not fully repaid before death.

Withdrawals

Withdrawals directly remove cash value from the policy. Unlike loans, they permanently reduce both the policy’s cash value and death benefit. If the amount withdrawn exceeds the policy’s cost basis (total premiums paid), the excess may be taxable. Withdrawals can also impact the policy’s ability to sustain itself, potentially leading to a lapse if insufficient cash value remains to cover charges.

Policy Surrender

Policy surrender terminates the life insurance policy in exchange for its cash surrender value. This value is the accumulated cash value minus any outstanding loans, unpaid premiums, and applicable surrender charges. Surrender charges are fees imposed by the insurer for early termination. Surrendering a policy means giving up the death benefit, and the policy ceases to exist.

Selling Your Life Insurance Policy

Beyond direct access from the insurer, policyholders can obtain funds by selling their life insurance policy to a third party. This offers an alternative to surrendering or taking out loans and withdrawals.

Viatical Settlements

Viatical settlements involve selling a life insurance policy by an individual who is terminally or chronically ill. The policyholder, known as the “viator,” sells their policy to a third-party provider for a lump sum payment. This payment is typically less than the policy’s full death benefit but more than its cash surrender value. The buyer becomes the new owner and beneficiary, assumes responsibility for future premium payments, and receives the death benefit when the insured passes away.

Life Settlements

Life settlements are similar to viatical settlements but are generally for policyholders who are older (often aged 65 or above) and not necessarily terminally or chronically ill. An existing life insurance policy is sold to an investor for a cash payment that exceeds the policy’s cash surrender value but is less than the death benefit. The process involves an application, an offer from a life settlement provider, and transfer of policy ownership to the buyer, who then pays premiums and receives the death benefit upon the insured’s death. Policyholders may pursue a life settlement if they no longer need coverage, cannot afford premiums, or require funds for other expenses.

Tax Considerations for Policy Access

Understanding tax implications is important when accessing funds from a life insurance policy. Each method has distinct tax consequences.

Policy Loans

Policy loans are generally not considered taxable income as long as the policy remains in force. However, if the policy lapses or is surrendered with an outstanding loan balance, the borrowed amount that exceeds the policyholder’s cost basis (total premiums paid) can become taxable income. This can result in an unexpected tax liability.

Withdrawals

Withdrawals from a life insurance policy are typically tax-free up to the amount of premiums paid into the policy (the cost basis). Any amount withdrawn exceeding this cost basis is usually taxable income, taxed at ordinary income rates. This “first-in, first-out” (FIFO) tax treatment means the return of your principal is not taxed, but any earnings above that principal are.

Policy Surrender

Surrendering a policy involves receiving the cash surrender value, and this transaction can result in taxable income. If the cash surrender value received is greater than the total premiums paid into the policy (the cost basis), the difference is subject to ordinary income tax. This gain is typically taxed in the year the policy is surrendered.

Viatical Settlements

For viatical settlements, proceeds are generally tax-free at the federal level, provided the policyholder is certified as terminally ill (with a life expectancy of 24 months or less) or chronically ill. This tax-exempt status was established for qualifying individuals. If life expectancy exceeds 24 months for a terminally ill individual, the settlement may be treated as a life settlement for tax purposes.

Life Settlements

Life settlements are typically subject to tiered taxation. Proceeds up to the policyholder’s cost basis (total premiums paid) are tax-free. Amounts received above the cost basis, up to the policy’s cash surrender value, are taxed as ordinary income. Any proceeds exceeding the policy’s cash surrender value are taxed as long-term capital gains. State tax treatment of life settlements can vary, aligning with each state’s general approach to income and capital gains taxes.