Can You Pull Money Out of Life Insurance?

Life insurance primarily provides a financial benefit to beneficiaries upon the insured’s death. However, certain policies also accumulate cash value over time. This cash value can become a financial resource accessible to the policyholder during their lifetime, offering flexibility for various financial needs.

Life Insurance Policies with Cash Value

Life insurance policies typically fall into two main categories: term life and permanent life. Term life insurance provides coverage for a specific period, such as 10 or 20 years, and generally does not build any cash value. In contrast, permanent life insurance policies are designed to offer coverage for an individual’s entire life and include a cash value component.

Whole life insurance policies feature a guaranteed cash value that grows at a fixed interest rate, with level premiums. A portion of each premium is allocated to the cash value, which steadily increases.

Universal life (UL) insurance offers more flexibility in premiums and death benefits. Its cash value grows based on an insurer-set interest rate, which may adjust but often has a guaranteed minimum. Policyholders can adjust premium payments, with excess contributions adding to cash value.

Variable universal life (VUL) insurance allows the policyholder to invest cash value in sub-accounts, similar to mutual funds, offering potential for higher returns but also greater market risk. Cash value growth within permanent policies is generally tax-deferred.

Methods for Accessing Policy Value

Policyholders can access the cash value accumulated within their permanent life insurance policies in several ways. Each method operates differently and affects the policy immediately.

One common method is taking a policy loan. The policyholder borrows funds from the insurer, using the cash value as collateral. Loans typically accrue interest. The policy remains in force, and the loan creates a lien against the cash value. If not repaid, the outstanding loan balance, including accrued interest, reduces the death benefit.

Another option is a partial withdrawal, or partial surrender. The policyholder withdraws a portion of the cash value. Unlike a loan, a withdrawal permanently reduces the policy’s cash value and decreases the death benefit by the amount withdrawn. Withdrawals up to the amount of premiums paid often have no immediate tax implications.

Finally, a policyholder can choose a full policy surrender. This terminates the life insurance policy entirely. Upon surrender, the insurer pays the cash surrender value, which is the accumulated cash value minus any surrender charges and outstanding loans. This ends the life insurance coverage, meaning no death benefit will be paid.

Tax Considerations for Policy Access

Accessing life insurance cash value involves specific tax implications. Tax treatment varies depending on the access method and policy structure.

Policy loans are generally not taxable income as long as the policy remains in force, as they are considered debt. However, if the policy lapses or is surrendered before repayment, the outstanding loan amount, up to the policy’s gain, can become taxable. Maintaining the policy avoids potential tax liabilities on unpaid loans.

Withdrawals from a policy’s cash value are typically tax-free up to the amount of premiums paid (the policy’s cost basis). If withdrawals exceed this cost basis, the excess is generally taxed as ordinary income. The “first-in, first-out” (FIFO) rule applies, meaning the cost basis is assumed to be withdrawn first.

A full policy surrender can lead to taxable income if the cash surrender value exceeds the policy’s cost basis. The difference between the cash value received and total premiums paid is considered a gain and is subject to ordinary income tax. This liability can be substantial if the policy has accumulated significant gains.

Modified Endowment Contracts (MECs) are a special consideration. If a policy fails the “7-pay test” due to excessive premiums within the first seven years, it becomes an MEC. For MECs, loans and withdrawals are subject to “last-in, first-out” (LIFO) taxation, meaning gains are withdrawn first and are immediately taxable. Withdrawals and loans from an MEC before age 59½ may also incur a 10% federal income tax penalty.

Impact on Policy and Future Benefits

Accessing a life insurance policy’s cash value has non-tax consequences that affect its structure and future benefits. These impacts should be carefully considered.

Taking a policy loan reduces the net death benefit available to beneficiaries. The outstanding loan balance, including any accrued interest, is subtracted from the death benefit when the insured passes away. This means the beneficiaries will receive a smaller payout than the policy’s face amount. If the loan grows too large, it can also increase the risk of the policy lapsing if the cash value is insufficient to cover policy charges.

Similarly, partial withdrawals directly decrease both the policy’s cash value and its death benefit. Since funds are permanently removed from the policy, there is less cash value available for future use or to support the policy’s ongoing costs. The death benefit is typically reduced dollar-for-dollar by the amount of the withdrawal.

A full policy surrender has the most definitive impact: it completely terminates the life insurance coverage. Once surrendered, the policy ceases to exist, and the death benefit is eliminated. There will be no payout to beneficiaries upon the insured’s death. This action ends the policy’s primary purpose of providing financial protection to loved ones.