How Can I Take Money Out of My Life Insurance?

Cash value life insurance represents a type of permanent life insurance that integrates a savings component alongside the traditional death benefit. This feature allows a portion of the premiums paid to accumulate over time, earning interest or investment returns. Policyholders can potentially access these accumulated funds for various financial needs during their lifetime. This article will explain the different ways policyholders can access the money within their policies, the associated tax implications, and the potential consequences for the policy itself.

Methods for Accessing Cash Value

Policyholders have several avenues to access the cash value built within their permanent life insurance policies. One common method involves taking a policy loan, where the policy’s cash value serves as collateral for the loan amount. The insurer lends money, and the policyholder is charged interest on the outstanding loan balance, typically at a lower rate than conventional personal loans. Repayment terms for these loans are often flexible, without rigid schedules, as the loan is secured by the policy’s own value. The policy generally remains in force even with an outstanding loan, and the cash value continues to grow.

Another way to access funds is through partial withdrawals, also known as partial surrenders. This involves directly taking a portion of the cash value from the policy. Unlike loans, withdrawals do not need to be repaid, providing direct access to the funds. However, making a withdrawal permanently reduces the policy’s cash value and can subsequently decrease the death benefit available to beneficiaries.

A more extensive method is a full policy surrender, which entails terminating the entire life insurance contract. Upon surrender, the policyholder receives the cash surrender value, which is the accumulated cash value minus any applicable surrender charges or outstanding loans. This action completely ends the insurance coverage, meaning no death benefit will be paid out to beneficiaries. Full surrender provides immediate access to accumulated cash but forfeits all future insurance protection.

Beyond direct access to cash value, some policies offer accelerated death benefits, also known as living benefits. These are features or riders that allow policyholders to access a portion of their death benefit while still alive, typically under specific qualifying circumstances. Common triggers include a diagnosis of a terminal illness with a limited life expectancy, often 12 or 24 months, or a chronic illness requiring long-term care. The funds received through accelerated death benefits are generally a percentage of the death benefit, ranging from 25% to 100%, and can be used for medical expenses or other needs. These benefits are distinct from loans or withdrawals against the cash value itself, as they draw directly from the death benefit.

Tax Considerations

Accessing funds from a life insurance policy carries various tax implications. Policy loans are generally treated as tax-free distributions as long as the policy remains active and in force. This tax-favored treatment stems from the loan being considered a debt against the policy’s value, rather than a distribution of earnings. However, if the policy lapses or is surrendered with an outstanding loan, the unpaid loan amount, to the extent it exceeds the premiums paid, can become taxable income.

Partial withdrawals from a life insurance policy are typically tax-free up to the policy’s “cost basis,” which represents the total amount of premiums paid into the policy. Any amount withdrawn that exceeds this cost basis is usually considered taxable income. This is based on the “first-in, first-out” (FIFO) accounting principle, where the tax-free return of principal is presumed to occur before any taxable gains.

When a policy is fully surrendered, the cash surrender value received is compared to the policy’s cost basis. If the cash surrender value exceeds the total premiums paid, the excess amount is considered taxable as ordinary income. This gain is taxed because the policy is no longer viewed as life insurance but as an investment that has generated a profit. Surrender charges may reduce the payout, but they do not reduce the taxable gain.

Accelerated death benefits are generally excluded from gross income for tax purposes if the insured is certified as terminally ill, with a life expectancy typically not exceeding 24 months. For chronically ill individuals, these benefits are also generally tax-free, provided they are used for qualified long-term care expenses and do not exceed certain per diem limits set by the IRS, which are $420 per day in 2024. Payments exceeding these limits or those not used for qualified purposes for chronic illness may become taxable. Certain scenarios, such as selling benefits to a third party or receiving interest on the payout, can also trigger taxability.

A significant tax consideration arises if a life insurance policy becomes a Modified Endowment Contract (MEC). A policy is classified as an MEC if the premiums paid exceed certain federal tax law limits, specifically failing the “7-pay test” within the first seven years of the policy. Once a policy is designated as an MEC, this classification is irreversible, and the tax treatment of withdrawals and loans changes. Distributions from an MEC are taxed on a “last-in, first-out” (LIFO) basis, meaning that any gains are considered to be withdrawn first and are immediately subject to income tax. Additionally, distributions from an MEC made before the policyholder reaches age 59½ may be subject to a 10% federal income tax penalty, similar to withdrawals from other tax-advantaged retirement accounts.

Consequences for Your Policy

Accessing the cash value of a life insurance policy directly impacts its future viability and the benefits it provides. Both withdrawals and outstanding policy loans reduce the ultimate death benefit payable to beneficiaries. If a policyholder dies with an unpaid loan balance, that amount, along with any accrued interest, is subtracted from the death benefit before it is paid out. Similarly, withdrawals permanently decrease the cash value, leading to a smaller death benefit.

Depleting the cash value through loans or withdrawals can increase the risk of the policy lapsing. If the cash value falls to a point where it can no longer cover the policy’s ongoing charges and fees, the policy could terminate. This is concerning if outstanding loan balances, with accrued interest, grow to exceed the available cash value, which can trigger a policy lapse and potential tax liabilities.

Reducing the cash value base through these access methods can impede the policy’s future growth. The cash value typically earns interest or investment returns, and a smaller base means less capital available for compounding, thereby slowing down or halting further accumulation. This can undermine the long-term financial planning objectives for which the policy was originally intended.

A full policy surrender, while providing immediate access to the cash value, results in the complete loss of all insurance coverage. This means the policy ceases to exist, and no death benefit will be paid to beneficiaries in the future. In some cases, accessing cash value might necessitate continued premium payments to keep the policy active, especially if the cash value was previously being used to offset premium costs. Without sufficient cash value or continued premium payments, the policy’s ability to remain in force is compromised.