Can You Take Out Money From a Life Insurance Policy?

Life insurance policies provide a financial safety net to beneficiaries upon the policyholder’s passing. Certain types of life insurance policies also offer an additional feature: the accumulation of cash value. This cash value component represents a portion of premiums paid that grows tax-deferred, separate from the death benefit. Policyholders can access this accumulated value during their lifetime, providing a potential source of funds for various financial needs. The ability to access this value depends on the policy type and the specific terms outlined in the insurance contract.

Accessing Funds Through a Policy Loan

One common method for accessing funds from a life insurance policy’s cash value is through a policy loan. This allows the policyholder to borrow money directly from their accumulated cash value. The policy remains in force during the loan period, and the unborrowed portion of the cash value continues to grow. However, the portion of the cash value that collateralizes the loan may earn interest at a different, often lower, rate or cease to earn interest, impacting overall policy performance.

Interest rates on policy loans are typically variable, fluctuating with prevailing market rates, and commonly range from 5% to 8% annually. This interest accrues on the outstanding loan balance, increasing the total amount owed. While repayment of the loan principal and interest is often optional, any outstanding loan balance, including accrued interest, will directly reduce the death benefit paid to beneficiaries. If the loan balance grows to exceed the cash value, the policy could lapse, leading to unfavorable tax consequences.

From a tax perspective, policy loans are generally not considered taxable income as long as the policy remains in force. This favorable tax treatment stems from the fact that the transaction is viewed as borrowing against an asset, not as a distribution of policy earnings. An exception occurs if the policy is classified as a Modified Endowment Contract (MEC) under Internal Revenue Code Section 7702A. For MECs, loans are treated as taxable distributions to the extent of any gain, and may also incur a 10% penalty if the policyholder is under age 59½.

Policy loans are a standard feature of permanent life insurance products, including whole life, universal life, and variable universal life insurance. If a loan is not repaid and the policy lapses or is surrendered, the outstanding loan amount that exceeds the policy’s cost basis could be considered taxable income to the policyholder, potentially creating an unexpected tax liability.

Accessing Funds Through a Cash Withdrawal

A direct cash withdrawal is another method for accessing funds from a life insurance policy. Unlike a policy loan, a withdrawal permanently removes funds from the cash value and is not repaid. This action reduces the policy’s cash value, diminishing its future growth and the death benefit. The death benefit is reduced by the withdrawal amount, providing less financial protection for heirs.

Withdrawals are generally limited to the cash value exceeding total premiums paid, known as the policy’s cost basis. Under the “cost basis first” rule, any withdrawal up to the cost basis is typically tax-free. This principle treats initial amounts as a return of the policyholder’s original capital investment.

If the withdrawal amount surpasses the policy’s cost basis, the portion representing accumulated gains becomes taxable. This gain is subject to ordinary income tax rates in the year of withdrawal. For example, if premiums paid are $50,000 and cash value is $75,000, a $65,000 withdrawal means $50,000 is tax-free, and $15,000 is taxable as ordinary income.

Cash withdrawals are primarily a feature of flexible premium policies, such as universal life and variable universal life insurance. While some whole life policies permit withdrawals, they are less common and can impact guaranteed features. Policyholders should assess the long-term implications of withdrawals, as they cannot be reversed.

Accessing Funds Through Policy Surrender

A complete policy surrender is the most conclusive method for accessing funds from a life insurance policy. Surrendering a policy entails formally terminating the entire insurance contract in exchange for its cash surrender value. This action is irreversible and immediately extinguishes the death benefit, along with all other associated policy benefits, such as riders for long-term care or disability.

The cash surrender value is determined by taking the policy’s accumulated cash value and deducting any applicable surrender charges, as well as any outstanding policy loans plus accrued interest. Surrender charges are fees assessed by the insurance company, particularly during the initial years of the policy, typically ranging from the first 5 to 20 years. These charges are designed to offset the insurer’s upfront costs, including agent commissions and administrative expenses, and can substantially reduce the cash amount received, especially if the policy is surrendered early in its life. The specific surrender charge schedule is clearly outlined in the policy contract provided at issuance.

The process for surrendering a policy generally requires the policyholder to submit a formal written request to the insurance company, often accompanied by specific forms and identification to verify ownership. The insurer will then calculate the final cash surrender value, considering all deductions, and disburse the funds, typically within a few business days or weeks.

From a tax perspective, the difference between the cash surrender value received and the total premiums paid into the policy, known as the cost basis, is considered taxable income. This gain is taxed as ordinary income in the year of surrender. For instance, if a policyholder paid $60,000 in premiums over the policy’s life and received a net cash surrender value of $85,000, the $25,000 gain would be subject to ordinary income tax rates applicable to the policyholder’s income bracket.

Conversely, if the cash surrender value received is less than the total premiums paid into the policy, there is generally no taxable gain. A policyholder cannot typically claim a tax deduction for the “loss” incurred when the surrender value is less than the premiums paid, as this is considered a personal expense rather than an investment loss for tax purposes. The finality of surrendering a policy means that the primary objective of life insurance—providing financial protection for beneficiaries—is permanently eliminated, making it a decision that requires thorough consideration of both financial and family protection needs before proceeding.