Can You Cash Out Life Insurance While Alive?

Life insurance provides a financial benefit to beneficiaries upon the insured’s death. Beyond this primary function, certain types of policies also accumulate “cash value.” This cash value is a separate, accessible fund that grows over time, distinct from the death benefit. Understanding how cash value works and how it can be accessed during a policyholder’s lifetime is important for life insurance planning.

Life Insurance Policies with Cash Value

Certain types of life insurance policies build cash value, offering a savings or investment component in addition to the death benefit. Whole life insurance allocates a portion of each premium to cash value, which grows on a tax-deferred basis at a guaranteed rate. Universal life policies also accumulate cash value, offering flexibility in premium payments and death benefits, with growth often linked to an interest rate set by the insurer.

Variable universal life allows policyholders to invest cash value in various sub-accounts, similar to mutual funds, providing potential for higher returns but also carrying investment risk. The growth of cash value in these policies is influenced by investment performance and can fluctuate. Term life insurance, by contrast, provides coverage for a specific period and typically does not build cash value, meaning it cannot be “cashed out” like permanent policies.

Ways to Access Your Policy’s Cash Value

Policyholders have several methods to access the cash value within their permanent life insurance policies while living. Each method serves distinct financial needs.

Policy Loan

A common approach is a policy loan, where the policyholder borrows money directly from the insurer, using the cash value as collateral. The loan amount can be up to a certain percentage of the cash value, and interest typically accrues on the outstanding balance. Policy loans do not require a credit check and generally do not have a set repayment schedule. However, any unpaid loan balance, including accrued interest, will reduce the death benefit paid to beneficiaries.

Cash Withdrawal

Another way to access funds is through cash withdrawals from the policy’s cash value. A policyholder can withdraw a specific amount, which directly reduces the policy’s cash value and, consequently, the death benefit. Unlike a loan, a withdrawal is a permanent reduction and does not need to be repaid. This option can be suitable for immediate financial needs, but it diminishes the policy’s future value and protective coverage.

Policy Surrender

Policy surrender involves terminating the life insurance policy entirely to receive its cash surrender value. This means the policyholder gives up the death benefit and all other policy features in exchange for the cash value, minus any applicable surrender charges. Surrender charges are fees imposed by the insurer, often declining over the first 10 to 20 years of the policy, and they reduce the net amount received. This action effectively ends the life insurance coverage.

Viatical and Life Settlements

For individuals facing specific circumstances, selling the policy through a viatical or life settlement can be an option. A viatical settlement involves selling a life insurance policy to a third-party for a lump sum, which is greater than the cash surrender value but less than the death benefit, when the policyholder has a life-threatening or chronic illness and a shortened life expectancy. Life settlements are similar but are generally for older individuals (typically age 65 or older) with a longer life expectancy who no longer need or can afford their policy. Both settlement types involve transferring ownership of the policy to the buyer, who then pays the premiums and receives the death benefit upon the insured’s passing.

Consequences of Accessing Cash Value

Accessing the cash value of a life insurance policy can have significant financial and tax consequences. The tax treatment varies considerably depending on the method used to access the funds.

Tax Implications

Policy loans are generally tax-free as long as the policy remains in force. However, if the policy lapses or is surrendered with an outstanding loan, the amount of the loan that exceeds the policy’s cost basis (the total premiums paid into the policy, less any prior tax-free withdrawals) can become taxable as ordinary income. If the policy is a Modified Endowment Contract (MEC), policy loans and withdrawals are taxed on a “last-in, first-out” (LIFO) basis, meaning earnings are considered to be withdrawn first and are subject to ordinary income tax and potentially a 10% penalty if the policyholder is under age 59½.

Cash withdrawals are generally tax-free up to the policy’s cost basis. Any amount withdrawn that exceeds the cost basis is taxable as ordinary income. This “cost recovery” rule means that the policyholder recovers their investment in the policy before any gains are subject to taxation. If the policy is a MEC, withdrawals are taxed on a LIFO basis, making earnings taxable first.

When a policy is surrendered, the policyholder receives the cash surrender value, which is the cash value minus any surrender charges and outstanding loans. The amount by which the cash surrender value exceeds the policy’s cost basis is taxable as ordinary income. This tax liability can be substantial if the policy has accumulated significant gains over its lifetime.

Viatical and life settlements have complex tax implications. For viatical settlements, the proceeds are generally tax-free if the insured is terminally ill (certified by a physician as having 24 months or less to live). If the insured is chronically ill but not terminally ill, the proceeds may be tax-free up to certain limits related to long-term care expenses. For life settlements, the portion of the proceeds up to the policy’s cost basis is generally tax-free. The amount received in excess of the cost basis but less than the policy’s net cash surrender value is taxed as ordinary income. Any amount received that exceeds the policy’s death benefit or net cash surrender value is taxed as a capital gain.

Impact on Death Benefit and Policy Lapse

Accessing cash value directly impacts the death benefit that beneficiaries would receive. Policy loans reduce the death benefit by the outstanding loan amount plus any accrued interest. Cash withdrawals permanently decrease both the cash value and the death benefit. Policy surrender eliminates the death benefit entirely, as the policy is terminated. Viatical and life settlements also eliminate the death benefit for the original beneficiaries, as the policy ownership is transferred to the third-party buyer.

Taking loans or withdrawals can also introduce the risk of policy lapse. If the cash value is reduced too much by loans or withdrawals, it may no longer be sufficient to cover the policy’s ongoing charges, such as administrative fees and the cost of insurance. If the policyholder does not pay additional premiums to cover these costs, the policy could lapse, resulting in the loss of coverage. Surrender charges, which can be a percentage of the premiums paid or the cash value, further reduce the net amount received, particularly if the policy is surrendered early in its life.