Can You Cash Out on a Life Insurance Policy?

Life insurance policies primarily provide financial protection to beneficiaries after the policyholder’s passing. However, some policies also offer a feature accessible during the policyholder’s lifetime: cash value. This accumulating value can serve as a financial resource, allowing individuals to access funds for various needs. Understanding how this value builds and the methods to access it is important for policyholders.

Understanding Life Insurance Cash Value

Cash value refers to a component within certain permanent life insurance policies that grows over time. This accumulated value functions like a savings or investment account, separate from the death benefit. A portion of each premium payment contributes to this cash value, in addition to covering insurance costs and policy expenses.

Cash value typically accumulates on a tax-deferred basis, meaning earnings are not taxed as they grow. This allows the cash value to compound more efficiently over time. The growth rate depends on the policy type and its terms.

Not all life insurance policies build cash value. Term life insurance, for instance, provides coverage for a specific period (e.g., 10, 20, or 30 years) and does not include a cash value component. These policies are generally more affordable but expire without any accumulated value if the insured outlives the term.

In contrast, permanent life insurance policies, such as whole life, universal life, variable universal life, and indexed universal life, cover an individual for their entire life and include a cash value feature. Whole life policies offer guaranteed cash value growth and fixed premiums. Universal life policies provide flexibility in premium payments and death benefits, with cash value growth tied to an interest rate. Variable universal life policies allow cash value to be invested in market-based sub-accounts, offering growth potential but also investment risk.

Beyond simply accumulating funds, cash value serves as a financial asset policyholders can access during their lifetime. It can help fund future premium payments, provide a source for loans, or act as a resource for unexpected expenses.

Methods for Accessing Policy Value

Policyholders with permanent life insurance can access their accumulated cash value during their lifetime in several ways. Each method has distinct processes and consequences for the policy and its death benefit.

Policy Surrender

Policy surrender involves terminating the life insurance contract. The policyholder receives the cash surrender value, which is the accumulated cash value minus any applicable surrender charges and outstanding loans. Surrendering the policy ends insurance coverage, meaning no death benefit is paid to beneficiaries.

Policy Loan

Policyholders can borrow against their policy’s cash value. The policy remains in force while the loan is outstanding, and the cash value continues to grow. Interest accrues on the loan; if not repaid, the outstanding amount reduces the death benefit.

Partial Withdrawals

Partial withdrawals allow policyholders to take a portion of their cash value directly. This reduces the policy’s cash value and may also reduce the death benefit. Unlike loans, withdrawals do not need repayment but permanently decrease the amount available in the policy.

Viatical and Life Settlements

These options are available for individuals, particularly those who are elderly or facing serious health conditions.

Viatical Settlement: A terminally or chronically ill policyholder sells their policy to a third party. The third party pays a lump sum (more than cash surrender value but less than the death benefit), takes over premium payments, and becomes the new beneficiary.
Life Settlement: For policyholders not terminally ill (often elderly or no longer needing coverage), the policy is sold to a third-party investor. The payment exceeds the cash surrender value but is less than the death benefit. The new owner assumes future premiums and receives the death benefit.

Key Considerations and Tax Consequences

Before accessing a life insurance policy’s value, policyholders should understand the potential impacts on coverage and associated tax implications.

Accessing cash value affects the policy’s death benefit. Surrendering the policy eliminates the death benefit entirely. Unpaid policy loans reduce the death benefit by the outstanding loan amount plus accrued interest. Similarly, partial withdrawals reduce both the cash value and potentially the death benefit. For viatical and life settlements, the policy is sold, meaning the original beneficiaries will not receive any death benefit.

Policy loans and withdrawals can also increase the risk of policy lapse. If cash value is depleted by loans or withdrawals and becomes insufficient to cover ongoing policy charges and premiums, the policy could terminate. This termination could occur if the policyholder stops making premium payments, leading to the policy lapsing and the loss of coverage.

Many permanent life insurance policies, especially in their early years, may impose surrender charges. These fees are deducted from the cash value if the policy is surrendered. Surrender charges typically range from 10% to 35% of the cash value and decrease over time, often disappearing after 10 to 15 years. This means that surrendering a policy early may result in receiving significantly less than the accumulated cash value.

The tax implications vary significantly for each access method.

Policy Surrender Tax

Any amount received above the “cost basis” is generally taxable as ordinary income. The cost basis refers to total premiums paid into the policy, less any prior tax-free withdrawals. For example, if a policyholder paid $50,000 in premiums and receives $60,000, the $10,000 gain is subject to ordinary income tax.

Policy Loan Tax

Policy loans are generally not considered taxable income as long as the policy remains in force. However, if the policy lapses or is surrendered with an outstanding loan, the loan amount exceeding the cost basis can become taxable income. This is because the outstanding loan is treated as a distribution upon policy termination.

Partial Withdrawal Tax

Partial withdrawals are typically treated as a return of premium first, which is tax-free up to the cost basis. Any amount withdrawn beyond the cost basis is then considered taxable income. For instance, if a policyholder paid $30,000 in premiums and withdraws $35,000, the first $30,000 is tax-free, and the remaining $5,000 is taxable.

Viatical and Life Settlement Tax

Tax treatment for viatical and life settlements can be complex. For terminally ill individuals, viatical settlement proceeds may be entirely tax-exempt. For chronically ill individuals, proceeds may also be tax-exempt up to certain limits.

For life settlements involving individuals not terminally or chronically ill, proceeds are typically taxed in a tiered manner. The amount received up to the cost basis (total premiums paid) is tax-free. Any amount received above the cost basis, up to the policy’s cash surrender value, is taxed as ordinary income, while proceeds exceeding the cash surrender value are generally taxed as capital gains.

Consulting with a financial advisor or tax professional is advisable to understand specific tax consequences.