Can You Withdraw From Your Life Insurance?

Life insurance policies primarily provide a financial safeguard for beneficiaries upon the policyholder’s death. However, certain types of life insurance offer an additional feature: the ability to access accumulated funds during the policyholder’s lifetime. This access is generally available through policies that build cash value, differing significantly from term life insurance, which typically provides coverage for a specific period without accumulating a cash component. Understanding these policies and access methods is important for financial flexibility.

Understanding Cash Value Life Insurance

Cash value refers to a savings component within certain life insurance policies that grows over time. A portion of each premium payment contributes to this cash value, which accumulates on a tax-deferred basis, meaning earnings are not taxed until they are withdrawn. Permanent life insurance policies, which cover an individual for their entire life, include a cash value feature. These include whole life insurance, where the cash value grows at a guaranteed fixed rate, and universal life insurance, which offers more flexibility in premiums and death benefits, with cash value growth often tied to market interest rates. Variable universal life and indexed universal life policies also build cash value, but their growth is linked to underlying investment performance or market indices, introducing a degree of risk and potential for greater returns.

Ways to Access Your Policy’s Cash Value

Policyholders have several methods to access the accumulated cash value within their permanent life insurance policies. Each method carries distinct implications for the policy, its death benefit, and potential tax consequences.

Policy Loan

One common method is taking a policy loan, where the policyholder borrows money from the insurance company, using the cash value as collateral. This is not a withdrawal of the cash value itself, but rather a loan against it, meaning the cash value continues to earn interest. Policy loans do not require credit checks and come with more favorable interest rates compared to conventional loans. While repayment is not mandatory, any outstanding loan balance, plus accrued interest, will reduce the death benefit paid to beneficiaries.

Cash Withdrawal

Another option is to make a cash withdrawal from the policy. This directly reduces the policy’s cash value and, consequently, the death benefit that will be paid to beneficiaries. Unlike loans, withdrawals do not need to be repaid. However, if the withdrawn amount exceeds the total premiums paid into the policy (known as the cost basis), the excess portion may be subject to income tax.

Surrender Policy

Finally, a policyholder can choose to surrender the policy, which means canceling the coverage entirely in exchange for the accumulated cash surrender value. The cash surrender value is the cash value minus any applicable surrender charges and outstanding loans. Surrendering the policy terminates the life insurance coverage, meaning no death benefit will be paid to beneficiaries. Surrender charges can be high, especially if the policy is surrendered in its early years, reducing the amount received.

Tax and Policy Considerations

Accessing the cash value of a life insurance policy involves tax and policy considerations that impact the financial outcome. Understanding these implications is important before making any decisions. The tax treatment varies depending on the method of access.

Policy Loans

Policy loans are considered tax-free distributions as long as the policy remains in force. However, if the policy lapses with an outstanding loan, the loan amount exceeding the policy’s basis may become taxable as ordinary income. Additionally, if the policy is classified as a Modified Endowment Contract (MEC) by the IRS, loans and withdrawals are treated differently; earnings are taxed first, and withdrawals or loans may be subject to a 10% federal penalty if the policyholder is under age 59½.

Cash Withdrawals

Cash withdrawals are tax-free up to the amount of premiums paid into the policy, as this is considered a return of the policyholder’s original investment or basis. Any amount withdrawn that exceeds this basis is taxable as ordinary income. For example, if a policyholder paid $20,000 in premiums and withdraws $25,000, the $5,000 gain would be taxable. Withdrawals also permanently reduce both the policy’s cash value and its death benefit.

Surrender Policy

When a policy is surrendered, the cash surrender value received is taxable to the extent it exceeds the total premiums paid into the policy. This excess, representing the gain on the policy, is taxed as ordinary income, not as capital gains. Surrender charges, which can range from 10% to 40% of the cash value, are deducted from the payout, particularly in the policy’s early years. Surrendering the policy eliminates the death benefit entirely, removing the financial protection for beneficiaries.

Steps for Accessing Your Life Insurance Funds

Accessing funds from your life insurance policy’s cash value is a procedural process.

Initial Contact

The initial step involves contacting your insurance provider directly. You can reach them through their customer service line, website portal, or by speaking with your assigned agent or financial professional.

Request Submission

Once contact is established, you will need to clearly state your intention to access the cash value and specify the method you wish to use, whether it is a loan, a withdrawal, or a policy surrender. The insurer will then provide you with the necessary forms and detailed instructions. These forms will require specific policy information, your personal details, and the amount you wish to access.

Processing and Disbursement

After completing and submitting the required documentation, the insurance company will process your request. The processing time can vary depending on the insurer and the complexity of the request, but it ranges from a few days to several weeks. For instance, receiving funds after surrendering a policy can take between 14 to 60 days. Funds are disbursed via check or direct deposit, according to your preference indicated on the forms.