Can You Take Money From Your Life Insurance Policy?

Life insurance policies can offer more than just a death benefit for beneficiaries; certain types also accumulate a cash value that policyholders can access during their lifetime. This cash value represents a savings component within the policy, growing over time through premium payments and interest or investment returns. This accumulated value provides a financial resource for various needs. Understanding how this cash value works and the options for accessing it is important.

Policy Types and Cash Value

Life insurance generally falls into two main categories: term life and permanent life insurance. Term life insurance provides coverage for a specific period and does not build any cash value. Permanent life insurance policies last for the insured’s life and include a cash value component that grows over time.

Whole life insurance is a type of permanent policy with a guaranteed cash value that grows at a fixed rate. A portion of each premium contributes to this cash value. This predictable growth means the cash value is assured to reach a certain amount by a specified age.

Universal life insurance offers more flexibility than whole life, allowing policyholders to adjust premiums and death benefits within certain limits. Its cash value grows based on an insurer-set interest rate, which may adjust periodically, but often includes a guaranteed minimum. This structure means cash value accumulation can vary depending on market conditions and the insurer’s performance.

Variable life insurance links its cash value growth to the performance of underlying investment options, such as stocks, bonds, or mutual funds. While this type of policy offers the potential for higher returns, it also carries greater risk as the cash value can fluctuate with market performance. A portion of the premium is allocated to investment subaccounts, and the cash value fluctuates based on their performance.

Methods of Accessing Cash Value

Policyholders can access the cash value in their permanent life insurance policies. These methods include taking a policy loan, making a partial withdrawal, or surrendering the policy entirely. Each option has unique mechanics and impacts on the policy’s benefits and cash value.

Policy loans allow policyholders to borrow money from the insurer, using their policy’s cash value as collateral. The loan accrues interest, which must be paid by the policyholder. While repayment of the loan principal is optional, any outstanding loan balance, plus accrued interest, will reduce the death benefit paid to beneficiaries if not repaid before the insured’s passing. The cash value continues to grow even with an outstanding loan, though loan interest can offset this growth.

Partial withdrawals take a portion of the cash value from the policy. These withdrawals permanently reduce the policy’s cash value and consequently lower the death benefit. Withdrawals are tax-free up to the amount of premiums paid into the policy (cost basis). Any amount above this cost basis may be subject to taxation.

Policy surrender means canceling the life insurance policy. When a policy is surrendered, the policyholder receives the cash surrender value, which is the accumulated cash value minus any outstanding loans or applicable surrender charges. Surrender charges may be imposed, especially if the policy is canceled early. Upon surrender, all insurance coverage ends, and the death benefit is forfeited.

Key Considerations When Accessing Funds

Accessing funds from a life insurance policy’s cash value carries important financial and policy implications. Understanding these consequences is essential for making informed decisions.

The impact on the death benefit is a primary concern when accessing policy funds. If a policy loan is not repaid, the outstanding loan amount, along with any accrued interest, will directly reduce the death benefit received by beneficiaries. Partial withdrawals similarly reduce the death benefit permanently, as the withdrawn funds are no longer part of the policy’s cash value. Surrendering the policy eliminates the death benefit entirely, as the coverage ceases upon cancellation.

Tax implications are a significant factor when accessing life insurance cash value. Policy loans are 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 untaxed loan amount may become taxable income if it exceeds the policy’s cost basis. Withdrawals are tax-free up to the policyholder’s cost basis (total premiums paid). Any amount exceeding this cost basis is taxable as ordinary income, following a “Last-In, First-Out” (LIFO) rule, where gains are considered withdrawn first.

Policy surrender also has tax consequences; if the cash surrender value received exceeds the total premiums paid into the policy, the difference is taxable as ordinary income. This gain is treated as regular income, not capital gains, and is subject to the policyholder’s applicable income tax rate.

A Modified Endowment Contract (MEC) designation significantly alters the tax treatment of a life insurance policy. A policy becomes an MEC if premiums paid exceed certain IRS limits, failing the “7-pay test.” Once classified as an MEC, its tax benefits are reduced, and distributions, including loans and withdrawals, are taxed differently. MEC withdrawals and loans are subject to LIFO taxation, meaning any gains are taxed first as ordinary income. Additionally, a 10% penalty may apply to taxable distributions if the policyholder is under age 59½.

Repaying a policy loan is advisable. Repaying the loan restores the cash value and, consequently, the full death benefit. Unpaid interest on loans can compound, potentially eroding the cash value and increasing the risk of the policy lapsing if the loan balance grows too large.

Accessing funds can also affect the policy’s future performance. Taking loans or withdrawals reduces the cash value, which can slow its future growth. This reduction might necessitate higher future premium payments to maintain coverage or prevent the policy from lapsing.