Can You Pull Money From a Life Insurance Policy?

Life insurance policies primarily offer a financial safety net to beneficiaries upon the policyholder’s passing. Beyond this fundamental purpose, certain types of life insurance policies can accumulate a “cash value” during the policyholder’s lifetime. This accumulated cash value may become an accessible resource for the policyholder, providing a potential financial tool separate from the death benefit. Understanding how this cash value works and how it can be accessed is important for policyholders.

Policies with Cash Value

Cash value in a life insurance policy grows over time and can be accessed by the policyholder. This accumulation occurs as a portion of premium payments is allocated to the cash value account, rather than solely covering insurance costs and administrative fees. The cash value then grows through guaranteed interest rates, declared dividends, or investment returns, depending on the policy type.

Different types of life insurance policies vary in cash value accumulation. Term life insurance policies provide coverage for a specific period, such as 10, 20, or 30 years, and do not build cash value. These policies are designed purely to provide a death benefit if the insured passes away within the specified term.

In contrast, permanent life insurance policies provide coverage for the policyholder’s entire life and include a cash value component. Examples include Whole Life, Universal Life, and Variable Universal Life insurance. Whole Life policies feature a guaranteed cash value growth rate and a level premium, providing predictability in its accumulation.

Universal Life policies offer flexibility, allowing policyholders to adjust premiums and death benefits, with cash value growth tied to a fluctuating interest rate. Variable Universal Life policies allow policyholders to direct the cash value into various investment sub-accounts, offering potential for higher returns but also carrying investment risk.

Accessing Policy Cash Value

Policyholders have several methods to access the cash value within their permanent life insurance policies. Each method carries distinct implications for the policy’s benefits and future viability. The choice of access method depends on the policyholder’s financial needs and long-term goals for the policy.

One method is taking a policy loan, where the policyholder borrows money directly from the insurer, using the cash value as collateral. This is not a traditional bank loan; it is an advance of the policy’s own funds. Interest accrues on the outstanding loan balance, and any unpaid loan balance and accrued interest will reduce the death benefit paid to beneficiaries. The policy remains in force as long as the cash value, less any outstanding loan, is sufficient to cover policy charges.

Another way to access cash value is through a cash withdrawal, where the policyholder takes out a portion of the cash. Unlike a loan, a withdrawal permanently reduces the policy’s cash value. This action also results in a corresponding reduction in the policy’s death benefit. Policy withdrawals can impact the future growth of the cash value and may require adjustments to future premium payments to maintain the policy.

Policy surrender involves the complete termination of the life insurance policy in exchange for its cash surrender value. This cash surrender value is the accumulated cash value minus any surrender charges and outstanding policy loans. When a policy is surrendered, all insurance coverage ceases, and the death benefit is eliminated.

Taxation and Policy Impact

Accessing a life insurance policy’s cash value can have financial and policy-related consequences, particularly concerning taxation and the policy’s long-term viability. Understanding these implications is important before utilizing the cash value. The tax treatment depends on the method used to access the funds.

Policy loans are considered tax-free distributions because they are treated as debt, not income, by the IRS. As long as the policy remains in force and does not lapse with an outstanding loan, the loan proceeds are not taxable. However, if the policy lapses or is surrendered with an outstanding loan balance, the amount of the loan exceeding the policyholder’s “cost basis” (premiums paid less any dividends received) becomes taxable as ordinary income.

Cash withdrawals are tax-free up to the policyholder’s cost basis. Any amount withdrawn that exceeds the cost basis is taxable as ordinary income. This “first-in, first-out” (FIFO) rule applies, meaning the IRS assumes that the premiums paid (your cost basis) are withdrawn first, before any taxable gains. For policies classified as Modified Endowment Contracts (MEC), withdrawals are treated differently under a “last-in, first-out” (LIFO) rule, meaning gains are considered withdrawn first and are subject to taxation and potentially a 10% penalty if the policyholder is under age 59½.

Surrendering a policy for its cash value can also have tax implications. If the cash surrender value received exceeds the policyholder’s cost basis, the difference is taxable as ordinary income. For example, if total premiums paid were $50,000 and the surrender value is $60,000, the $10,000 gain would be taxable. Outstanding policy loans reduce the death benefit by the loan amount plus any accrued interest.

Cash withdrawals directly reduce the death benefit by the amount withdrawn. Policy surrender eliminates the death benefit. There is also a risk of policy lapse if loans are not managed or if significant withdrawals deplete the cash value. If the cash value falls too low to cover policy charges and outstanding loan interest, the policy could terminate, leading to a loss of coverage and potential tax liabilities on any gains if it was a MEC.