Can You Cash Out a Life Insurance Policy While Alive?

It is possible to access funds from a life insurance policy while the policyholder is still alive, though the specific methods and their availability depend on the type of policy owned. This process is often referred to as “cashing out” a life insurance policy.

Understanding Cash Value Life Insurance

Cash value refers to a savings component within certain life insurance policies that accumulates over time. This accumulated value can grow on a tax-deferred basis, serving as a financial resource that policyholders might access during their lifetime. A portion of each premium payment, along with potential investment gains, contributes to this cash value.

Permanent life insurance policies, such as whole life, universal life, and variable life, are designed to build cash value. Whole life insurance typically offers guaranteed cash value growth at a fixed interest rate, providing predictability. Universal life insurance provides more flexibility, with cash value growth often tied to current interest rates, and it may allow for adjustable premiums.

Variable life insurance permits policyholders to invest the cash value in various sub-accounts, similar to mutual funds, which offers potential for higher returns but also involves greater risk due to market fluctuations. In contrast, term life insurance does not build cash value. Term policies focus solely on providing a death benefit for a specified period.

Accessing Your Policy’s Cash Value

Policyholders have several distinct methods for accessing the cash value of their life insurance policy while they are still alive. Each method has specific mechanics and immediate consequences for the policy’s coverage.

A common approach is taking a policy loan, where the policyholder borrows money from the insurer using the cash value as collateral. The policy remains in force, and interest accrues on the loan. Any outstanding loan balance, including accrued interest, will reduce the death benefit paid to beneficiaries upon the insured’s passing.

Another option is a cash withdrawal, which involves directly taking funds from the policy’s accumulated cash value. Unlike a loan, withdrawals do not need to be repaid. However, withdrawing funds permanently reduces the policy’s cash value and, consequently, decreases the death benefit available to beneficiaries.

Policy surrender involves terminating the entire policy in exchange for its cash surrender value. This means the death benefit is forfeited, and the policy ceases to exist. The cash surrender value is typically the accumulated cash value minus any surrender charges or outstanding loans. Surrender charges can be substantial, especially if the policy is terminated within the first 10 to 15 years.

Accelerated death benefits, also known as living benefits riders, allow policyholders to access a portion of their death benefit under specific qualifying circumstances. These circumstances typically include a diagnosis of a terminal illness with a limited life expectancy, often 12 to 24 months, or a chronic illness preventing daily living activities. Accessing these benefits reduces the ultimate death benefit paid to beneficiaries.

Life settlements and viatical settlements involve selling the life insurance policy to a third-party investor. Viatical settlements are for terminally or chronically ill policyholders. Life settlements generally apply to policyholders who are elderly or seriously ill but not necessarily terminally ill. The policyholder receives a lump sum payment, which is usually more than the cash surrender value but less than the full death benefit. The new owner then takes over premium payments and receives the death benefit when the insured passes away, meaning the original policyholder no longer owns the policy and their beneficiaries receive nothing.

Tax Implications of Cash Value Access

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

Policy loans are generally not considered taxable income because they are treated as a debt against the policy’s cash value. However, a taxable event can occur if the policy lapses or is surrendered with an outstanding loan balance. In such cases, any loan amount that exceeds the policy’s cost basis, which is the total premiums paid, may become taxable income.

For cash withdrawals, amounts are generally tax-free up to the policy’s cost basis. If the withdrawal amount exceeds the total premiums paid into the policy, the excess portion is typically taxable as ordinary income. This is because the IRS views amounts beyond the cost basis as investment gains.

When a policy is surrendered, any amount received that exceeds the policy’s cost basis is taxable as ordinary income. If the cash surrender value is less than the cost basis, a deductible loss is generally not recognized for tax purposes. The gain is taxed as ordinary income rather than capital gains because surrendering a policy to the insurer is not considered a sale or exchange.

Accelerated death benefits are generally tax-free if the insured meets specific criteria, such as being certified by a physician as terminally ill (expected to live 24 months or less) or chronically ill (unable to perform at least two activities of daily living). These payments are typically considered an advance on the tax-free death benefit.

The tax treatment of life settlements and viatical settlements can be complex. For life settlements, the amount received up to the policy’s cost basis is generally tax-free. The portion received between the cost basis and the cash surrender value is typically taxed as ordinary income. Any amount received above the cash surrender value is generally taxed as capital gains. For viatical settlements, especially for terminally ill individuals, the proceeds are often entirely tax-free under specific IRS rules, provided certain conditions are met, such as a life expectancy of 24 months or less. If the individual is chronically ill, the proceeds may also be tax-free if used for qualified long-term care expenses.