Can You Cash Out Life Insurance When You Leave a Job?

Many individuals receive life insurance coverage as an employment benefit without fully understanding its nature or what happens to it when they change jobs. Employer-provided life insurance offers financial protection for beneficiaries, but its characteristics differ significantly from independently purchased policies. A common question is whether these policies can be “cashed out” upon job separation. This article aims to clarify employer-sponsored life insurance types, options when leaving a job, and how cash value, if present, can be accessed, and its associated tax implications.

Understanding Employer-Provided Life Insurance

Employer-provided life insurance policies typically fall into two main categories. The most prevalent is group term life insurance, which provides coverage for a specific period, usually while employed. This type is often employer-paid and frequently provides a death benefit equivalent to one or two times an employee’s annual salary. Group term life insurance policies generally do not accumulate cash value and therefore cannot be cashed out.

Many employers also offer voluntary or supplemental life insurance. This allows employees to purchase additional coverage, often through payroll deductions, to complement the employer-paid benefit. While some voluntary policies are term-based, others are permanent types, such as whole life or universal life, which include a cash value component. Cash value is a savings element within a permanent policy that grows over time on a tax-deferred basis. Only policies that accumulate this cash value can potentially be accessed or “cashed out” by the policyholder.

Options for Employer-Provided Life Insurance Upon Job Separation

When employment ends, employer-provided life insurance options depend on the policy type and insurer. Group term life insurance typically terminates automatically on the last day of employment or shortly thereafter. Many group policies include a “conversion privilege,” allowing former employees to convert their group term policy into an individual permanent policy, such as whole life or universal life. This conversion usually occurs without new medical underwriting, which can be advantageous for individuals with health changes. The request to convert must be made within a specific timeframe, often 30 or 31 days after employment termination, and premiums for the individual policy will likely be higher than the group rate.

For voluntary or supplemental life insurance, individuals may have additional options, including portability. Portability allows a former employee to continue their existing group term coverage as an individual term policy, often at group rates, directly with the insurer. This option is generally available for a limited period, such as 18 to 24 months, and may have age restrictions, often for employees under age 70. If the voluntary policy was permanent with cash value, it can usually be continued by taking over premium payments directly. If it was a term policy, it may also offer a conversion option.

Accessing Cash Value from Life Insurance

The concept of “cashing out” life insurance applies exclusively to policies that have accumulated cash value. Most employer-provided group term life insurance policies do not build cash value and therefore cannot be cashed out. Accessing cash value is primarily relevant for individual permanent life insurance policies or voluntary permanent policies obtained through an employer.

Policy Surrender

One method to access cash value is through a policy surrender, where the policyholder terminates the policy in exchange for its cash surrender value. The cash surrender value is typically the accumulated cash value minus any surrender charges, outstanding loans, or fees. Upon surrender, the life insurance coverage ceases entirely.

Policy Loans

Another option is to take a policy loan against the cash value. Policy loans are not withdrawals but rather advances against the death benefit, with interest accruing on the borrowed amount. An outstanding loan reduces the death benefit paid to beneficiaries if not repaid.

Partial Withdrawals

Finally, some permanent policies, particularly universal life, allow for partial withdrawals of the cash value. These withdrawals directly reduce the policy’s cash value and typically the death benefit.

Tax Implications of Accessing Life Insurance Cash Value

Accessing cash value from a life insurance policy can have significant tax consequences, depending on the method. When a policy is surrendered, any amount received exceeding the total premiums paid (the “cost basis”) is generally considered taxable ordinary income. For example, if $20,000 in premiums were paid and the surrender value is $30,000, the $10,000 gain would be taxed.

Policy loans are generally not considered taxable income when taken, as they are treated as debt rather than a distribution. However, if the policy lapses or is surrendered with an outstanding loan, the untaxed portion of the loan, up to the policy’s gain, may become taxable. For withdrawals from policies like universal life, the funds are typically treated as a tax-free return of premium up to the cost basis first. Any amount withdrawn exceeding the cost basis is subject to ordinary income tax.

A special consideration arises if a policy is classified as a Modified Endowment Contract (MEC). A policy becomes an MEC if it is overfunded, failing the IRS’s “7-pay test,” which limits premiums paid during the first seven years. For MECs, withdrawals and loans are taxed differently; they are treated on a “last-in, first-out” (LIFO) basis, meaning gains are considered withdrawn first and are immediately taxable as ordinary income. Furthermore, distributions from an MEC, including loans, taken before age 59½ may be subject to an additional 10% penalty tax, similar to rules for non-qualified annuities.