Can You Take Money Out of Life Insurance?

Life insurance primarily provides a financial safety net for beneficiaries after the policyholder’s passing. However, certain types of life insurance policies allow access to accumulated funds during the insured’s lifetime. This access can provide a flexible financial resource for various needs, extending the policy’s utility beyond its death benefit.

Types of Policies Allowing Cash Access

A cash value component enables policyholders to access funds during their lifetime. This cash value is a portion of premiums paid into permanent life insurance policies that grows over time on a tax-deferred basis. It functions as a savings or investment account within the policy.

Whole life insurance is a permanent policy that builds cash value with guaranteed growth and fixed premiums. A portion of each premium contributes to this cash value, which grows at a set rate over the policy’s lifetime.

Universal life insurance offers more flexibility in premiums and death benefits compared to whole life. Its cash value accumulates based on interest, and policyholders can adjust payments or the death benefit. This flexibility allows for overpayments into the cash value or using accumulated funds to cover future premiums.

Variable universal life insurance includes an investment component, where the cash value fluctuates based on the performance of underlying investment options, such as stocks or mutual funds. Policyholders can direct funds into separate variable accounts, influencing the cash value’s growth or decline. This policy also offers flexibility in premiums and death benefits, similar to universal life. Term life insurance does not build cash value because it provides coverage for a specific period without a savings component.

Methods for Accessing Cash Value

Policyholders with cash value life insurance have several ways to access accumulated funds. Each method involves specific mechanics and immediate effects on the policy.

One method is taking a policy loan, which means borrowing money from the insurance company using the policy’s cash value as collateral. Policy loans generally do not require credit checks or a formal approval process, making them accessible. The loan amount is typically limited to a percentage of the cash value, often up to 90%.

Interest accrues on the outstanding loan balance. Repayment is flexible and not always on a strict schedule, and the interest rate is usually lower than other personal loans. If the loan and accrued interest are not repaid, the outstanding balance will reduce the death benefit paid to beneficiaries. Should the loan balance, including interest, grow to exceed the policy’s cash value, the policy could lapse, resulting in a loss of coverage.

Another way to access funds is through cash withdrawals, which directly remove a portion of the cash value from the policy. Unlike a loan, a withdrawal is a permanent removal of funds and does not need to be repaid. This action reduces the policy’s cash value and can also decrease the death benefit. Partial withdrawals are common, but they directly diminish the cash value available for future growth or other uses. Some policies, like universal life, allow for partial withdrawals.

The third method is surrendering the policy, which involves terminating the life insurance coverage in exchange for its cash surrender value. The cash surrender value is the accumulated cash value minus any applicable surrender charges and outstanding loans or interest. Surrender charges may apply, particularly if the policy is canceled in its early years, and these charges can significantly reduce the amount received. Surrendering the policy means forfeiting the death benefit, as coverage ends upon surrender.

Tax Considerations and Policy Impact

Accessing cash value from a life insurance policy carries specific tax implications and affects the policy’s long-term financial structure. Understanding these consequences is important for sound financial decision-making.

Policy loans are not considered taxable income as long as the policy remains in force. This tax-free treatment holds true provided the loan amount does not exceed the total premiums paid. However, if a policy lapses or is surrendered with an outstanding loan, the loan amount exceeding premiums paid can become taxable as ordinary income. This can lead to an unexpected tax bill, particularly if the policy’s cash value includes significant gains. The interest charged on policy loans is not tax-deductible.

Cash withdrawals have different tax rules, primarily governed by the “cost basis.” Withdrawals are tax-free up to the amount of premiums paid into the policy, as this is considered a return of the policyholder’s capital. Any amount withdrawn that exceeds this cost basis, representing investment gains, is taxable as ordinary income. For example, if $20,000 in premiums were paid and $25,000 is withdrawn, the $5,000 gain would be taxable.

Modified Endowment Contracts (MECs) have specific considerations. If a policy is classified as an MEC due to excessive premium payments, withdrawals are taxed on a “last-in, first-out” (LIFO) basis, meaning earnings are considered withdrawn first and are fully taxable. Additionally, withdrawals from MECs before age 59½ may be subject to a 10% federal income tax penalty, similar to withdrawals from qualified retirement plans.

Surrendering a policy also has tax implications. Any gain realized upon surrender, defined as the cash surrender value minus the total premiums paid, is taxable as ordinary income. For instance, if a policy with $120,000 in paid premiums is surrendered for $150,000, the $30,000 gain is taxable. This taxable amount is treated as regular income, not capital gains, and is subject to the policyholder’s income tax rate.

Regardless of the method chosen, accessing the cash value impacts the policy’s death benefit. Policy loans reduce the death benefit by the outstanding loan amount if not repaid. Withdrawals directly reduce both the cash value and the death benefit. Surrendering the policy eliminates the death benefit since coverage is terminated. These actions also diminish the policy’s future cash value growth potential, as the base from which it grows is reduced.