How Life Insurance That Can Be Cashed Out Works

Life insurance policies that can be “cashed out” refer to those that build an accumulated cash value over time. This cash value component is a feature of certain permanent life insurance policies, distinguishing them from term life insurance which typically does not accumulate cash value. While the primary purpose of life insurance remains to provide a death benefit to beneficiaries upon the policyholder’s passing, the cash value offers a unique “living benefit” that can be accessed during the policyholder’s lifetime. This aspect allows policyholders to utilize a portion of their policy’s value for various financial needs, providing a flexible resource beyond just a future payout. The accumulation of this cash value transforms the policy into a financial asset that can be leveraged under specific conditions.

Types of Life Insurance with Cash Value

Permanent life insurance policies provide lifelong coverage and include a cash value component that grows over time. The two main categories are Whole Life and Universal Life, each with distinct features. Whole life insurance offers a guaranteed death benefit and cash value growth rate. A portion of each premium is allocated to the cash value, growing at a fixed interest rate. This predictability makes it a stable, conservative option.

Universal life offers flexible premiums and death benefits, with variable cash value growth. Payments can be adjusted, and cash value grows based on a periodically changing insurer-declared interest rate. Variations include Indexed Universal Life (IUL) and Variable Universal Life (VUL). IUL policies link cash value growth to a market index (e.g., S&P 500) without direct investment, including a guaranteed minimum rate and a cap on gains for balanced participation and protection.

Variable Universal Life (VUL) policies offer the highest growth potential but also the most risk. Cash value is invested in sub-accounts, similar to mutual funds. Growth is directly tied to investment performance, meaning it can increase or decrease significantly. This provides control but requires the policyholder to bear investment risk.

How Cash Value Grows

Cash value accumulation is a structured process. A portion of each premium is directed towards the policy’s cash value, building from early years. The specific premium percentage allocated varies by policy type and insurer fees.

Cash value grows through interest crediting or investment performance. Whole life policies credit interest at a guaranteed rate, ensuring predictable growth. Universal life policies credit interest based on a declared rate, which can fluctuate but often has a guaranteed minimum. Participating whole life policies may also pay dividends, which can purchase additional paid-up insurance, reduce premiums, or be taken as cash.

Policy fees and charges (e.g., mortality, administrative, surrender) are deducted from cash value or premiums. These cover insurance costs and administration, slowing cash value accumulation, especially in initial years.

Accessing Your Policy’s Cash Value

Policyholders can access cash value through several methods, each impacting the death benefit and policy viability. A common approach is a policy loan, borrowing against the cash value. The loan amount is typically limited to a percentage of accumulated cash value, with interest accruing on the outstanding balance. While repayment is not required during the policyholder’s lifetime, any unpaid loan balance reduces the death benefit.

Another option is a partial withdrawal from the cash value. Unlike a loan, a withdrawal directly reduces the policy’s cash value and death benefit. There is no obligation to repay, and it generally does not accrue interest. However, withdrawing funds can diminish the policy’s ability to maintain itself, potentially leading to a lapse if insufficient cash value remains to cover ongoing charges.

The most definitive way to access cash value is by surrendering the policy. When surrendered, insurance coverage terminates, and the policyholder receives the cash surrender value (accumulated cash value minus surrender charges and outstanding loans). Surrender charges are fees levied during early policy years to recoup insurer expenses. Surrendering forfeits the death benefit and ends coverage.

Tax Implications of Cash Value

Life insurance cash value offers tax-deferred growth. As it accumulates through interest or investment gains, earnings are not subject to current income tax. This allows compounding without annual tax erosion, leading to greater accumulation compared to taxable accounts. Tax deferral continues as long as the policy remains in force.

Accessing cash value through policy loans is generally tax-free if the policy remains active. The IRS views loans as borrowing against an asset, not taxable income. However, if a policy with an outstanding loan lapses or is surrendered, the loan amount exceeding the cost basis (total premiums paid) can become taxable.

Withdrawals from cash value are typically tax-free up to the policyholder’s cost basis (total premiums paid). Any amount withdrawn exceeding the cost basis is taxable income. For example, a $60,000 withdrawal from $50,000 in premiums results in $10,000 taxable income.

When a policy is surrendered, any amount received exceeding the cost basis is subject to ordinary income tax. Policies accumulating cash value too quickly relative to their death benefit can be classified as Modified Endowment Contracts (MECs) under IRC Section 7702A. MECs lose some favorable tax treatments; withdrawals and loans are taxed on a “last-in, first-out” (LIFO) basis, with gains taxed first. Withdrawals from an MEC before age 59½ may also be subject to a 10% penalty tax.