Can You Cash Out Life Insurance Early?

Life insurance primarily serves to offer financial protection to beneficiaries after the policyholder’s passing, providing a death benefit that can help support loved ones during a difficult time. However, a common inquiry arises regarding the ability to access value from a life insurance policy while the policyholder is still living.

Understanding Life Insurance Policy Value

Life insurance policies can be categorized into two main types: term life and permanent life. Term life insurance provides coverage for a specific period and typically does not accumulate any cash value. In contrast, permanent life insurance policies, such as whole life, universal life, variable universal life, and indexed universal life, feature a component known as “cash value.” This cash value represents a portion of the premiums paid into the policy that grows over time.

The cash value within a permanent life insurance policy accumulates through a combination of premium payments, interest earned, and sometimes dividends. A portion of each premium payment goes towards covering the cost of insurance and administrative fees, while the remainder is allocated to the cash value account. This accumulated value grows on a tax-deferred basis, meaning that earnings are not taxed until they are withdrawn. The cash value is distinct from the death benefit, which is paid to beneficiaries upon the policyholder’s death; the cash value is a living benefit accessible during their lifetime.

Methods for Accessing Policy Value

Policyholders with permanent life insurance have several ways to access their accumulated cash value. One common method is a policy surrender, which involves terminating the policy in exchange for its cash surrender value. This amount is the cash value minus any surrender charges or outstanding loans, and it ends the insurance coverage. To surrender, the policyholder contacts their insurer, completes a request form, and provides documentation.

Another option is to take a policy loan, where the policyholder borrows money directly from the insurer, using the cash value as collateral. These loans typically accrue interest, often at rates ranging from 3% to 8% annually, but they do not require a credit check or repayment schedule. If the loan and accrued interest are not repaid, the outstanding balance will reduce the death benefit paid to beneficiaries. Policyholders contact their insurer to request a loan.

Alternatively, a policyholder can make a partial withdrawal from the cash value. This involves taking out a portion of the accumulated funds directly from the policy. Unlike a loan, withdrawals permanently reduce the policy’s cash value and can also decrease the death benefit. Withdrawals are typically tax-free up to the amount of premiums paid into the policy, often referred to as the cost basis. To make a partial withdrawal, the policyholder contacts their insurer to confirm the amount and submit a request.

Financial and Coverage Implications of Early Access

Accessing life insurance policy value early carries financial and coverage implications that policyholders should consider. When a policy is surrendered, any amount received that exceeds the total premiums paid into the policy (the cost basis) is generally considered taxable income. This gain is taxed as ordinary income, not capital gains. For example, if $50,000 in premiums were paid and the cash surrender value is $60,000, the $10,000 gain would be taxable.

Policy loans are generally not considered taxable income as long as the policy remains in force. However, if the policy lapses with an outstanding loan, or if the policy is classified as a Modified Endowment Contract (MEC) and a loan is taken, the loan amount may become taxable. When funds are withdrawn, they are typically tax-free up to the amount of premiums paid. Any withdrawals exceeding this cost basis are usually taxed as ordinary income.

Both policy loans and withdrawals directly reduce the death benefit payable to beneficiaries. If a loan is not repaid, the outstanding loan balance, plus any accrued interest, is subtracted from the death benefit when the policyholder passes away. Similarly, partial withdrawals directly deplete the cash value, which in turn reduces the amount available for the death benefit. Depleting the cash value through loans or withdrawals can also increase the risk of the policy lapsing if the remaining cash value is insufficient to cover policy charges or if premium payments cease. This situation could necessitate higher future premium payments to prevent the policy from terminating.

Alternatives to Cashing Out

For policyholders needing financial liquidity, other options exist besides fully cashing out their life insurance. A life settlement involves selling the life insurance policy to a third-party investor for a lump sum. This amount is typically more than the policy’s cash surrender value but less than the full death benefit. Life settlements are often considered by older policyholders (typically over age 65) or those with declining health who no longer need or can afford coverage.

Another alternative is utilizing accelerated death benefits, also known as living benefits. Many permanent life insurance policies include riders that allow policyholders to access a portion of their death benefit while still alive under specific circumstances. These circumstances often include being diagnosed with a terminal illness, chronic illness, or critical illness. The amount accessible and the conditions for accessing it vary by policy and insurer, and the funds received reduce the eventual death benefit paid to beneficiaries.