Can You Withdraw Your Life Insurance Cash Value?

Life insurance policies primarily offer financial protection to beneficiaries upon the policyholder’s death. Certain types, however, also serve as a source of funds during the policyholder’s lifetime. Term life insurance provides coverage for a specific period, while permanent life insurance is intended to last for an individual’s entire life. The ability to access funds while alive is a distinguishing feature primarily associated with permanent life insurance policies, offering flexibility for unexpected expenses or long-term financial planning.

Understanding Cash Value Life Insurance

Cash value refers to a savings component embedded within certain types of permanent life insurance policies. This component accumulates over time, providing a living benefit that policyholders can access during their lifetime. A portion of each premium payment contributes to this cash value, which grows on a tax-deferred basis. This growth means earnings are not taxed until they are withdrawn.

The accumulation of cash value varies by policy type. Whole life insurance policies offer a guaranteed cash value growth rate and fixed premiums, making their accumulation predictable. Universal life insurance policies provide more flexibility, with cash value growth tied to an interest rate set by the insurer, potentially with a guaranteed minimum. Variable universal life insurance allows policyholders to invest the cash value in various sub-accounts, such as stocks or bonds, offering potential for higher returns but also greater risk based on market performance. Indexed universal life insurance is another type where cash value growth is linked to a market index, like the S&P 500, with downside protection. The cash value represents a portion of the premium set aside that earns interest or investment returns.

In contrast, term life insurance policies do not build cash value. These policies provide coverage for a specific period, such as 10, 20, or 30 years, and do not have a savings or investment component. Policyholders cannot access funds from a term life insurance policy while they are alive because there is no cash value to draw upon.

Methods for Accessing Policy Funds

Accessing funds from a cash value life insurance policy can be achieved through several methods: cash withdrawals, policy loans, and policy surrender.

Cash Withdrawals

Cash withdrawals involve taking a portion of the policy’s accumulated cash value. This process requires contacting the insurer and submitting a request form. A cash withdrawal reduces the policy’s death benefit, directly lowering the payout beneficiaries would receive. Large withdrawals can also diminish the policy’s remaining cash value, impacting its future growth and long-term financial performance.

Policy Loans

Policy loans allow policyholders to borrow money using their policy’s cash value as collateral. To obtain a policy loan, the policyholder contacts the insurer. Policy loans accrue interest, at rates ranging from 5% to 8%, which can be fixed or variable. If the loan, including accrued interest, is not repaid, the outstanding balance will be deducted from the death benefit when the policyholder passes away. Unmanaged policy loans can increase the risk of policy lapse if the loan balance and interest grow to exceed the available cash value.

Policy Surrender

Policy surrender is terminating the life insurance policy in exchange for its cash surrender value. This process involves formally notifying the insurer and completing a surrender request form. Upon surrender, the policy’s death benefit is canceled entirely. The cash surrender value is the accumulated cash value minus any surrender charges, which can be substantial, especially in the early years of the policy. These charges decrease over time, and some policies may have no surrender charges after a certain period, such as 10 to 15 years.

Tax Implications of Accessing Funds

Tax rules for accessing cash value from a life insurance policy vary by method. Basis refers to the total amount of premiums paid into the policy.

Cash Withdrawals

For cash withdrawals, amounts taken are tax-free up to the policy’s basis. If the withdrawal amount does not exceed the total premiums paid, it is not subject to income tax. If the withdrawal exceeds the basis, the portion representing gains or earnings on the cash value becomes taxable as ordinary income. For example, if you paid $50,000 in premiums and withdraw $60,000, the initial $50,000 is tax-free, but the additional $10,000 is taxable income.

Policy Loans

Policy loans are not considered taxable income, provided the policy remains in force. This is because a loan is a debt against the policy’s cash value, not a distribution of earnings. However, a tax consequence can arise if the policy lapses or is surrendered with an outstanding loan. In such cases, the outstanding loan amount, to the extent it exceeds the policy’s basis, may be treated as a taxable distribution and subject to ordinary income tax. This can create an unexpected tax liability, particularly if the policy has accumulated substantial gains.

Policy Surrender

When a policy is surrendered for its cash surrender value, any amount received that exceeds the policy’s basis is taxable as ordinary income. The Internal Revenue Service (IRS) considers this excess a gain on the investment component of the policy. For instance, if you paid $70,000 in premiums and the cash surrender value is $90,000, the $20,000 gain would be taxable. This gain is taxed at ordinary income rates, not capital gains rates. This tax liability can be substantial if the policy has been held for many years and has accrued significant earnings.

Other Financial Considerations

Beyond tax implications, other financial considerations arise when accessing funds from a cash value life insurance policy. These factors affect the policy’s long-term viability and its ability to meet its original purpose.

Impact on Growth

One primary consideration is the impact on the policy’s long-term financial performance and growth. When cash value is withdrawn or borrowed against, it reduces the money remaining in the policy’s cash value account. This reduction can slow or halt the compounding growth characteristic of these policies, as there is less capital on which to earn interest or investment returns. Over time, this can lead to a smaller overall cash value than originally projected, diminishing the policy’s potential as a savings or investment vehicle.

Policy Lapse

Another factor is the potential for policy lapse. If withdrawals or outstanding policy loans significantly deplete the cash value, there may be insufficient funds remaining to cover policy charges, such as the cost of insurance and administrative fees. When the cash value can no longer sustain these charges, the policy may enter a grace period, and if not rectified, it can ultimately lapse. A lapsed policy means the termination of coverage, resulting in no death benefit being paid to beneficiaries.

Fees and Charges

Policyholders should be aware of any associated fees or charges for accessing funds. While policy loans do not incur direct fees beyond interest, withdrawals or surrenders may be subject to surrender charges, especially if accessed within the first 10 to 15 years of the policy’s life. These charges can be a significant percentage of the cash value, reducing the net amount received. Policyholders should understand the fee structure outlined in the policy contract before initiating any access method.

Impact on Death Benefit

Finally, accessing funds directly impacts the policy’s primary purpose. Life insurance is designed to provide a death benefit to beneficiaries, offering financial security upon the policyholder’s passing. When cash value is withdrawn or reduced by loans, the death benefit paid to beneficiaries will be correspondingly lower. This can undermine the original goal of income replacement or legacy planning, potentially leaving beneficiaries with less financial support than intended.