How Can You Cash Out a Life Insurance Policy?

Life insurance serves as a financial contract that provides a death benefit to beneficiaries upon the insured’s passing, offering financial protection. Beyond this primary function, certain types of life insurance policies allow individuals to access accumulated funds during their lifetime. This article explores ways policyholders can “cash out” or access value within their life insurance policies.

Understanding Cash Value Life Insurance

Life insurance policies fall into two main categories: term life and permanent life insurance. Term life insurance provides coverage for a specific period (e.g., 10, 20, or 30 years) and typically does not build cash value. Once the term expires, the policy ends, and there are no accumulated funds to access.

In contrast, permanent life insurance policies provide coverage for the insured’s entire life and include a savings or investment component known as “cash value.” This cash value grows over time on a tax-deferred basis, accumulating equity. Common types that build cash value include whole life, universal life, variable universal life, and indexed universal life. This cash value is the source of funds policyholders may access.

Accessing Your Policy’s Cash Value

Policyholders with permanent life insurance have several methods to access their policy’s cash value, allowing for financial flexibility.

One common method is taking a policy loan, where you borrow money from the insurer using your policy’s cash value as collateral. The loan is not a withdrawal from the cash value but an advance from the insurer, and interest accrues on the borrowed amount. If not repaid, the outstanding balance, including accrued interest, will reduce the death benefit paid to beneficiaries. Policy loans typically do not require a credit check and often have flexible repayment terms compared to traditional bank loans.

Another option is making withdrawals from the cash value. This involves taking funds directly from the policy’s value. Withdrawals reduce the cash value and can lower the policy’s death benefit. Generally, withdrawals are tax-free up to the amount of premiums paid into the policy, considered a return of your cost basis.

Policy surrender involves canceling the life insurance policy entirely to receive its cash surrender value. This value is the cash value minus any applicable surrender charges or outstanding loans. Surrendering the policy ends insurance coverage, meaning no death benefit will be paid upon the insured’s death. Surrender charges can be significant in early years but typically decrease over time.

Accelerated death benefits, also known as living benefits, allow policyholders to access a portion of their death benefit while still alive under specific circumstances. These typically involve terminal illness with limited life expectancy, or chronic illness requiring long-term care. While an advance on the death benefit rather than access to cash value, it provides funds to cover medical or living expenses during a difficult time.

Selling Your Life Insurance Policy

Beyond accessing internal cash value, an alternative method to “cash out” a life insurance policy is to sell it to a third party through a life settlement. This involves selling ownership of an existing permanent life insurance policy to an investor for a lump sum. The amount received is typically greater than the policy’s cash surrender value but less than the full death benefit.

Once sold, the new owner assumes responsibility for paying all future premiums. Upon the insured’s death, the new owner receives the death benefit. Individuals often consider a life settlement if they no longer need coverage, cannot afford premiums, or require immediate funds.

The process typically begins with an application and review of medical records and policy information to determine eligibility. The life settlement provider evaluates factors like the insured’s age, health, the policy’s death benefit, and premium costs. If an offer is accepted, ownership transfers, and the cash payment is typically disbursed through an escrow agent. A variation, a viatical settlement, applies to policyholders who are terminally or chronically ill, often with different tax implications.

Tax Considerations for Cashing Out

Understanding tax implications of accessing life insurance policy funds is important, as tax laws can be complex. Consult a qualified tax professional for personalized guidance.

Policy loans are generally not taxable income as long as the policy remains in force. However, if the policy lapses or is surrendered with an outstanding loan, the loan amount exceeding the cost basis (total premiums paid) can become taxable.

Withdrawals from a policy’s cash value are typically tax-free up to the premiums paid into the policy, which represents your cost basis. Any amount withdrawn exceeding this cost basis is usually taxable ordinary income. If the policy is classified as a Modified Endowment Contract (MEC), withdrawals may be taxed differently, with interest taxed first and potentially subject to a 10% penalty if the policyholder is under age 59½.

When a policy is surrendered, any gain (the cash surrender value received that exceeds total premiums paid) is generally taxable as ordinary income. For example, if you paid $40,000 in premiums and received $55,000 upon surrender, the $15,000 gain would be taxable.

Accelerated death benefits are generally tax-free if the insured is certified as terminally ill (often with a life expectancy of 24 months or less) or chronically ill. For chronically ill individuals, benefits must be used for qualified long-term care expenses, and amounts exceeding specific IRS per diem limits may be taxable.

Proceeds from a life settlement can be subject to taxation, typically following a three-tiered structure. The portion up to the policy’s cost basis (premiums paid) is generally tax-free. The amount received above the cost basis, up to the policy’s cash surrender value, is typically taxed as ordinary income. Any remaining proceeds above the cash surrender value are usually taxed as capital gains. However, viatical settlements for the terminally or chronically ill are generally tax-free.