Can You Cash Out Life Insurance Before You Die?

Life insurance serves as a financial safety net, providing monetary support to beneficiaries after the insured’s passing. Many policyholders wonder if this value can be accessed during their lifetime. Cashing out a life insurance policy depends on the policy type and available mechanisms for accessing its accumulated value. These methods involve significant tax implications.

Policy Types and Cash Value

Life insurance policies generally fall into two main categories: term life and permanent life insurance. Term life insurance provides coverage for a specific period, such as 10, 20, or 30 years, and does not build cash value. If the insured outlives the policy term, coverage ceases unless renewed, and no funds are returned. This policy type focuses on providing a death benefit if the insured dies within the specified term.

Permanent life insurance policies offer lifelong coverage and typically include a cash value component. This cash value is a savings or investment element that accumulates over time, distinct from the death benefit. A portion of each premium payment goes towards the cost of insurance, while another part is allocated to this cash value account, where it grows tax-deferred. The cash value can be accessed by the policyholder during their lifetime for various purposes.

Whole life insurance is a common type of permanent policy where the cash value grows at a guaranteed interest rate. The growth is predictable and steady, and premiums typically remain fixed for the life of the policy. This guaranteed growth provides a stable foundation for long-term financial planning. Some whole life policies may also pay dividends, which can further increase the cash value if reinvested.

Universal life insurance offers more flexibility than whole life, allowing policyholders to adjust premium payments and death benefits within certain limits. The cash value in a universal life policy grows based on interest rates set by the insurer or tied to market performance, often with a guaranteed minimum rate. Premium payments can be varied, and a portion can be directed towards the tax-deferred cash value account. If premium payments are insufficient, the policy’s cash value can be used to cover the shortfall, but this can lead to policy lapse if the value is depleted.

Variable universal life insurance is another permanent policy type where the cash value is invested in various sub-accounts, similar to mutual funds. Cash value growth is tied directly to the performance of these underlying investments, offering the potential for higher returns but also carrying greater risk. This policy type provides flexibility in premiums and death benefits, much like universal life, but the investment component introduces market volatility. Indexed universal life insurance also links cash value growth to a stock market index, such as the S&P 500, often with a floor and cap on returns, balancing risk and reward.

Methods for Accessing Policy Value

Accessing the accumulated value within a permanent life insurance policy can be achieved through several distinct mechanisms. Each method has specific mechanics and outcomes for the policy and its death benefit, providing liquidity for various life events or emergencies.

Surrendering the policy involves terminating the life insurance contract. The policyholder receives the cash surrender value, typically the accumulated cash value minus any applicable surrender charges or outstanding loans. This action ends the insurance coverage, meaning the death benefit will no longer be paid. Surrender charges are fees imposed by the insurer for early termination, particularly during the initial years of the policy.

Policy loans allow policyholders to borrow directly against their policy’s cash value. The cash value serves as collateral for the loan, and the interest rate charged on these loans is typically competitive, often lower than conventional loan rates. Repayment of the loan is not mandatory on a strict schedule, but interest accrues on the outstanding balance. If the loan and accrued interest are not repaid, the outstanding amount will reduce the death benefit.

Withdrawals are another way to access cash value, primarily available in universal life policies. Policyholders can take out portions directly. Unlike loans, withdrawals permanently reduce the policy’s cash value and, consequently, the death benefit. Excessive withdrawals can deplete the cash value, potentially leading to policy lapse if there are insufficient funds to cover policy charges and the cost of insurance.

Accelerated death benefits, also known as living benefits riders, allow policyholders to access a portion of their death benefit while alive under specific qualifying conditions. These typically involve a diagnosis of a terminal illness with a limited life expectancy (often 12 or 24 months), or a chronic illness preventing daily living activities. The funds received can be used for any purpose, such as medical expenses, long-term care, or improving the quality of life. The advanced portion reduces the amount paid to beneficiaries.

Life settlements involve selling an existing life insurance policy to a third-party investor for a lump sum. The payout is typically more than the policy’s cash surrender value but less than the full death benefit. The buyer assumes ownership, pays future premiums, and receives the death benefit when the insured dies. This option is generally available to policyholders aged 65 or older, or those with a significant health change.

A viatical settlement is a specific type of life settlement for individuals with a terminal or chronic illness, often with a life expectancy of two years or less. Similar to a life settlement, the policyholder sells their policy to a third party for immediate cash. Proceeds are typically higher than the cash surrender value and provide financial relief for medical and living expenses. The buyer takes over premium payments and becomes the beneficiary.

Tax Considerations for Accessed Value

Understanding the tax implications of accessing life insurance policy value is essential, as the IRS treats different methods distinctly. Tax treatment often hinges on whether funds are considered a return of premiums, a policy gain, or a loan.

When surrendering a life insurance policy, any amount received exceeding the policyholder’s “cost basis” is generally taxable as ordinary income. The cost basis refers to the total premiums paid into the policy, less any prior tax-free withdrawals or dividends. For example, if a policyholder paid $50,000 in premiums and receives $65,000 upon surrender, the $15,000 gain is typically subject to ordinary income tax.

Policy loans are generally tax-free as long as the policy remains in force. This is because the loan is viewed as a debt against the policy’s cash value, not as a withdrawal of earnings. However, if the policy lapses or is surrendered with an outstanding loan, any portion of the loan amount that exceeds the premiums paid into the policy can become taxable income. This can create a significant tax liability, especially if substantial gains have accumulated within the policy.

Withdrawals from a life insurance policy are typically tax-free up to the cost basis (premiums paid). Amounts withdrawn beyond this are generally taxed as ordinary income. A specific consideration arises if the policy is classified as a Modified Endowment Contract (MEC). A policy becomes an MEC if it fails the “7-pay test,” meaning too much premium has been paid into it too quickly, exceeding federal tax law limits. For MECs, withdrawals and loans are taxed on a “last-in, first-out” (LIFO) basis, meaning that any gains are considered to be withdrawn first and are immediately taxable as ordinary income. Additionally, withdrawals from an MEC before age 59½ may incur a 10% federal income tax penalty, similar to early withdrawals from retirement accounts.

Accelerated death benefits are generally tax-free if certain conditions are met, primarily that the insured is certified as terminally or chronically ill under IRS guidelines. For a terminal illness, this typically means a life expectancy of 24 months or less. For a chronic illness, the individual must be unable to perform a certain number of daily living activities, and the proceeds must be used for qualified long-term care expenses. These payments are treated as an advance on the tax-free death benefit.

The tax treatment of life settlements can be complex, involving three components. First, the portion of proceeds representing the policyholder’s cost basis (premiums paid) is generally tax-free. Second, any amount received above the cost basis but up to the policy’s cash surrender value is typically taxed as ordinary income. Third, any remaining proceeds above the cash surrender value are usually taxed as capital gains. Viatical settlements, however, are generally tax-free under federal law if the insured meets IRS criteria for terminal or chronic illness, as they are considered an advance of the life insurance benefit.