How to Cash In a Life Insurance Policy

Life insurance policies can offer more than just a death benefit; many accumulate a cash value accessible during the policyholder’s lifetime. This feature allows individuals to tap into their policy’s accumulated funds for various financial needs. Understanding how this process works involves recognizing the types of policies that build cash value, the methods available for accessing these funds, and the associated financial considerations. Navigating these options carefully can provide a valuable financial resource, but requires understanding the implications for the policy and its beneficiaries.

Understanding Policies with Cash Value

Not all life insurance policies are designed to accumulate cash value. Term life insurance, for instance, provides coverage for a specific period and does not build a cash component. This type of policy focuses solely on providing a death benefit to beneficiaries if the insured passes away within the specified term.

In contrast, permanent life insurance policies offer coverage for an individual’s entire life and include a savings or investment component that generates cash value. Whole life insurance grows cash value at a guaranteed rate. Universal life insurance offers flexibility with premiums and death benefits, and its cash value grows based on interest rates. Variable universal life insurance includes an investment component, with cash value fluctuating based on chosen options.

Options for Accessing Cash Value

Policyholders with cash value life insurance have primary methods to access their accumulated funds: surrendering the policy or taking a policy loan. Each option carries distinct mechanics and consequences for the policy and its future benefits. Before initiating either process, it is important to understand the current cash value and any specific terms outlined in the policy.

Surrendering a policy involves completely terminating the insurance coverage. When a policy is surrendered, the policyholder receives the cash surrender value, which is the accumulated cash value minus any applicable surrender charges and outstanding policy loans. This action means the policy no longer provides a death benefit, and the original insurance contract ends.

Alternatively, a policy loan allows the policyholder to borrow money using the policy’s cash value as collateral. The policy remains in force, and the loan is not issued by a traditional lender but by the insurance company itself. Interest accrues on the borrowed amount. While repayment is flexible, any outstanding loan balance, including accrued interest, will reduce the death benefit paid to beneficiaries if the loan is not repaid before the insured’s death.

Financial Implications of Accessing Cash Value

Accessing a life insurance policy’s cash value involves several financial considerations, including how the cash surrender value is calculated, potential tax liabilities, and the impact on the death benefit. The actual amount received from surrendering a policy, known as the cash surrender value, is less than the policy’s total accumulated cash value. This difference accounts for deductions like outstanding loans and surrender charges.

Surrender charges are fees imposed by the insurer if the policy is terminated within a certain period, early in the policy’s life. These charges can be substantial, ranging from 10% to 35% of the cash value in the initial years, gradually decreasing and disappearing after 10 to 15 years. The exact fee structure is outlined in the policy contract and is a factor in determining the net payout.

From a tax perspective, withdrawals or surrenders from a cash value life insurance policy are tax-free up to the policyholder’s “cost basis.” The cost basis represents the cumulative amount of premiums paid into the policy, reduced by any untaxed distributions or previous withdrawals. Any amount received above this cost basis is considered taxable income and is taxed at ordinary income rates.

An important consideration is whether the policy has been classified as a Modified Endowment Contract (MEC). A policy becomes an MEC if the premiums paid exceed certain IRS limits, specifically failing the “7-pay test” within the first seven years. Once designated an MEC, the policy loses some of the favorable tax treatment associated with life insurance.

Withdrawals and loans from an MEC are subject to “last-in, first-out” (LIFO) taxation, meaning that earnings are presumed to be withdrawn first and are taxed as ordinary income. Additionally, distributions from an MEC before age 59½ may incur a 10% penalty tax, similar to early withdrawals from retirement accounts. This MEC status is permanent and cannot be reversed.

Policy loans, in contrast to withdrawals or surrenders, are not considered taxable income as long as the policy remains in force. This is because they are treated as a debt against the policy, not a distribution of gains. However, if a policy lapses with an outstanding loan balance that exceeds the policyholder’s cost basis, the amount exceeding the basis becomes taxable as ordinary income. The interest rates on policy loans range from 5% to 8%, and while repayment is flexible, unpaid interest can increase the loan balance, potentially leading to a policy lapse.

Accessing cash value impacts the policy’s primary purpose. Surrendering the policy entirely eliminates the death benefit for beneficiaries. If a policy loan is taken but not fully repaid, the outstanding loan balance, plus any accrued interest, will be deducted from the death benefit amount. Beneficiaries will receive a smaller sum than the policy’s face value.

Executing the Access Process

Once a policyholder decides to access their life insurance cash value, they must initiate the formal process with the insurance carrier. The first action is to contact the insurer directly, either through their customer service department, a dedicated agent, or an online portal. This initial contact will clarify the specific steps and forms required for either a policy surrender or a policy loan.

The insurance company will provide the necessary forms, which must be completed accurately and thoroughly. For a surrender, this includes a surrender request form, while a loan will require a policy loan agreement. Review all sections of these documents, ensuring that policy numbers, desired amounts, and personal details are correct.

Along with the completed forms, the insurer may request supporting documentation to verify identity and policy ownership. Common requirements include a government-issued identification and proof of address. Once all paperwork and required documentation are gathered, the submission process can begin.

Submission methods vary by insurer but include mailing original documents, submitting them through a secure online portal, or delivering them in person to a local office. After submission, the insurer will process the request. The timeframe for receiving funds can vary; for a policy surrender, it takes 7 to 30 business days for funds to be disbursed. Policy loans have quicker processing times, as they involve less administrative complexity than a full surrender.

After the request has been submitted and processed, the policyholder should expect a confirmation from the insurer. This confirmation will detail the transaction, the amount disbursed, and any remaining policy value or changes to the death benefit. Keep a record of all communications and documents related to the transaction for future reference.