Can You Cash Out a Life Insurance Policy Early?

Life insurance primarily serves as a financial safety net, providing a death benefit to beneficiaries upon the policyholder’s passing. Certain types of life insurance policies also offer financial flexibility during the policyholder’s lifetime. These policies allow access to accumulated funds, which can be a valuable resource for various needs. Understanding the mechanisms and implications of accessing these funds early is important for policyholders.

Understanding Cash Value in Life Insurance

Cash value refers to a savings component within certain life insurance policies that grows over time. This accumulated fund can be accessed by the policyholder during their lifetime, offering a financial resource beyond the death benefit. Cash value differentiates permanent life insurance from term life insurance.

Permanent life insurance policies, such as whole life, universal life, and variable universal life, are designed to last for the policyholder’s entire life and include a cash value component. A portion of each premium payment is allocated to this account, which typically grows on a tax-deferred basis. The cash value can accumulate through a guaranteed interest rate, current interest rates, or investment performance, depending on the policy type.

Conversely, term life insurance provides coverage for a specific period, such as 10, 20, or 30 years, and does not build cash value.

Ways to Access Your Policy’s Cash Value

Policyholders with permanent life insurance have several avenues to access the accumulated cash value within their policies. Each method carries distinct characteristics and implications for the policy, its death benefit, and the policyholder’s financial situation.

• Policy Surrender: This involves terminating the life insurance contract in exchange for its cash surrender value. The cash surrender value is the accumulated cash value minus any applicable surrender charges, outstanding loans, or fees. Upon surrender, the policy ceases to exist, and the death benefit is no longer available to beneficiaries.
• Policy Loan: Policyholders can borrow money directly from the insurance company, using the policy’s cash value as collateral. Loans typically do not require a credit check and often have flexible repayment terms. Interest accrues on the loan, and if not repaid, the loan and accumulated interest will reduce the death benefit. Insurance companies generally allow borrowing up to 90% of the policy’s cash value.
• Partial Withdrawals: Some permanent policies, particularly universal life insurance, permit partial withdrawals from the cash value. A partial withdrawal directly reduces the policy’s cash value and, consequently, the death benefit. Unlike a policy loan, withdrawals are permanent and do not need to be repaid.
• Accelerated Death Benefits: Also known as living benefits, these provisions allow policyholders to access a portion of their policy’s death benefit while still alive, under specific qualifying circumstances. These circumstances typically include a terminal illness with a limited life expectancy (e.g., 24 months or less), chronic illness, or critical illness. This is an advance on the death benefit, not a withdrawal or loan from the cash value itself. The remaining death benefit is paid to beneficiaries upon the policyholder’s death.
• Viatical or Life Settlement: This involves selling the life insurance policy to a third-party company for a lump sum. In a viatical settlement, the policyholder is typically terminally ill, while a life settlement is generally for older policyholders who are not terminally ill. The third-party buyer takes over premium payments and receives the death benefit when the insured passes away. This option results in the policyholder giving up all ownership rights and the death benefit.

Tax and Financial Considerations of Early Access

Accessing the cash value of a life insurance policy or selling the policy can have significant financial and tax implications. Policyholders should carefully consider these consequences to make informed decisions.

Impact on the Death Benefit

A primary consequence of accessing cash value is the impact on the death benefit. Whether through a policy loan, partial withdrawal, or surrender, the amount accessible during the policyholder’s lifetime will reduce or eliminate the amount ultimately paid to beneficiaries. For instance, an unpaid policy loan, including accrued interest, will be deducted from the death benefit.

Surrender Charges and Fees

When surrendering a policy, surrender charges and fees are often applied, especially in the early years. These charges recover the insurer’s upfront costs and can significantly reduce the cash surrender value received. Surrender charges can range from 10% or more in the first year and typically decrease over time, often phasing out entirely after a period of a few years to 15 years.

Taxation of Gains

The taxation of gains is a primary consideration for many early access methods. Generally, the amount received that exceeds the policy’s “cost basis” is taxable as ordinary income. The cost basis refers to the total premiums paid into the policy, less any prior untaxed distributions. If a policy is surrendered, any cash value received above this cost basis is subject to income tax.

Policy Loan Taxation

For policy loans, the borrowed funds are generally not considered taxable income, as they are treated as a loan against the policy’s value. However, if the policy lapses with an outstanding loan, the loan amount exceeding the policy’s cost basis can become taxable. This can lead to an unexpected tax liability if the policy terminates prematurely.

Accelerated Death Benefits Taxation

Accelerated death benefits are typically tax-free if certain conditions are met, such as the policyholder being certified as terminally ill (with a life expectancy of 24 months or less) or chronically ill. For chronically ill individuals, the proceeds must generally be used for qualified long-term care expenses to maintain tax-free status. If the medical condition does not meet IRS definitions or if the benefits exceed certain per diem limits for chronic illness, a portion may be taxable.

Viatical and Life Settlements Taxation

The taxation of viatical and life settlements can be complex. Under the Tax Cuts and Jobs Act of 2017 (TCJA), the cost basis for these transactions is generally the cumulative premiums paid. Proceeds received up to the cost basis are not taxable. Any amount received above the cost basis up to the policy’s cash surrender value is taxed as ordinary income, and any remaining proceeds above the cash surrender value are taxed as capital gains. However, if the insured is terminally or chronically ill and meets specific IRS criteria, the proceeds from a viatical settlement may be entirely tax-free.