Can You Take Money Out of Your Life Insurance Policy?

Life insurance provides financial protection to beneficiaries upon the insured’s death. Beyond its primary function, certain policies can accumulate cash value over time. This accumulated value can become a potential source of funds for the policyholder during their lifetime. Understanding how this value builds and methods available to access it is important. This article explores how policyholders can tap into their policy’s value, outlining the processes involved and the subsequent financial and tax implications.

Life Insurance Policy Types and Cash Value

Life insurance policies are categorized by whether they build cash value, distinguishing permanent from term life insurance. Cash value is a savings or investment element within a policy, separate from the death benefit. It typically grows tax-deferred through premiums and, sometimes, investment returns or interest credited by the insurer.

Permanent life insurance policies, such as Whole Life, Universal Life, and Variable Universal Life, remain in force for the insured’s entire life if premiums are paid. Whole Life insurance features a guaranteed cash value growth rate and a fixed premium, offering predictable accumulation.

Universal Life insurance offers more flexibility than Whole Life, allowing policyholders to adjust premium payments and death benefits. Its cash value grows based on an interest rate declared by the insurer, which can fluctuate. Variable Universal Life insurance allows policyholders to direct cash value into investment sub-accounts, offering potential for higher returns but carrying investment risk.

Conversely, Term Life insurance policies provide coverage for a specific period, such as 10, 20, or 30 years. These policies are designed purely for protection and generally do not build cash value. Therefore, policyholders cannot access funds from a Term Life policy during its active term.

Ways to Access Policy Value

Policyholders with permanent life insurance policies have several avenues to access the accumulated cash value during their lifetime without necessarily terminating coverage.

Policy Loan

A policy loan allows the policyholder to borrow money directly from the insurer, using the policy’s cash value as collateral. The policy remains in force, and the loan amount is not typically withdrawn from the cash value itself but rather extended by the insurer against that value. Interest accrues on the loan. Policyholders can repay the loan at their own pace, or the outstanding loan balance plus accrued interest will be deducted from the death benefit upon the insured’s passing.

Partial Withdrawal

A partial withdrawal, also known as a partial surrender, allows the policyholder to directly take out a portion of the accumulated cash value. Unlike a loan, a withdrawal permanently reduces the policy’s cash value and typically results in a corresponding reduction in the death benefit. The policy generally remains in force, but its future growth potential and ultimate payout are diminished.

Cash Surrender

A cash surrender involves terminating the entire life insurance policy. When a policy is surrendered, the insurer pays the policyholder the accumulated cash surrender value, which is the cash value less any surrender charges or outstanding loans. Surrendering the policy ends all coverage, and no death benefit will be paid.

Accelerated Death Benefits

Some life insurance policies offer accelerated death benefits, also known as living benefits. This feature allows a policyholder to receive a portion of their policy’s death benefit while still living, under specific qualifying circumstances. These circumstances typically include a diagnosis of a terminal, chronic, or critical illness. Accelerated death benefits draw from the death benefit itself, triggered by health events rather than financial need alone.

Financial and Tax Considerations

Accessing the value within a life insurance policy carries various financial and tax implications. These consequences can affect the policy’s long-term viability, its ability to provide a death benefit, and the policyholder’s tax liability.

Any funds accessed from a life insurance policy, whether through loans, withdrawals, or surrenders, will directly reduce the death benefit payable to beneficiaries. An outstanding policy loan, including accrued interest, will be subtracted from the death benefit. Partial withdrawals permanently reduce the death benefit. A full cash surrender eliminates the death benefit entirely.

Accessing funds can also diminish the policy’s cash value and future growth potential. Loans or withdrawals reduce the cash value available to generate future returns. If the remaining cash value becomes insufficient to cover ongoing policy charges, such as administrative fees and the cost of insurance, the policy could lapse, leading to a loss of coverage. This risk is more pronounced if the policyholder stops paying premiums or if investment performance in variable policies is poor.

The tax treatment of funds accessed from life insurance policies varies by method. Policy loans are generally tax-free distributions, provided the policy remains in force. However, if the policy lapses or is surrendered with an outstanding loan, the untaxed portion of the loan, up to the amount of gain in the policy, can become taxable income.

Withdrawals, or partial surrenders, are generally treated on a “cost basis” rule. This means withdrawals are considered a tax-free return of premium payments up to the policyholder’s “cost basis” (total premiums paid). Any amount withdrawn exceeding this cost basis is taxable income. For example, if a policyholder paid $50,000 in premiums and withdraws $60,000, the first $50,000 is tax-free, and the remaining $10,000 is subject to income tax.

When a life insurance policy is fully surrendered for its cash value, the difference between the cash surrender value received and the total premiums paid (the gain) is considered taxable income. For instance, if a policyholder paid $70,000 in premiums and receives $90,000 upon surrender, the $20,000 gain is taxable at ordinary income tax rates.

A specific consideration arises with Modified Endowment Contracts (MECs). An MEC is a life insurance policy that has accumulated cash value too quickly, exceeding certain IRS-defined limits. Once classified as an MEC, any loans or withdrawals are subject to less favorable tax treatment under the “Last-In, First-Out” (LIFO) rule, where all gains are considered distributed first and are immediately taxable. If the policyholder is under age 59½, these taxable distributions from an MEC may also be subject to a 10% federal penalty tax.

The risk of policy lapse is a financial consideration when accessing policy value. If loans or withdrawals reduce the cash value to a point where it can no longer cover ongoing policy charges, the policy may terminate. A lapse results in the loss of the death benefit and can trigger a taxable event if there are outstanding loans or if the policy had a gain.