How to Cash Out Life Insurance While Alive

Life insurance policies can provide a financial safety net for beneficiaries and a source of accessible funds during a policyholder’s lifetime. Certain types of life insurance accumulate cash value, offering options to access funds. This article explains how cash value functions within a policy and details avenues for accessing these funds while alive.

Understanding Your Life Insurance Policy’s Cash Value

Cash value is a savings component within certain life insurance policies that grows over time. This feature is typically found in permanent life insurance policies, such as whole life, universal life, variable universal life, and indexed universal life. Term life insurance, in contrast, generally does not include a cash value component. A portion of each premium payment is allocated to this cash value account, alongside funds for insurance costs and administrative expenses.

The cash value grows in different ways depending on the policy type. Whole life policies typically offer a guaranteed interest rate, providing predictable growth. Universal life policies also accumulate cash value, often with a guaranteed minimum interest rate, but their growth can be more market-dependent. For variable universal life and indexed universal life policies, the cash value growth is tied to the performance of selected investments or market indices, offering potential for higher returns but also carrying more risk. The earnings within the cash value grow on a tax-deferred basis, meaning taxes are not paid on the growth until the funds are accessed.

Policyholders can monitor their cash value accumulation through annual statements provided by their insurance company. For more up-to-date information, policyholders can contact their insurance provider directly or access their policy details through online portals.

Options for Accessing Cash Value from Your Insurer

Accessing the cash value directly from the insurance company typically involves three primary methods: policy loans, cash withdrawals, and policy surrender. Each option has distinct mechanics and consequences for the policy’s future. The choice depends on the policyholder’s financial needs and desire to maintain coverage.

Policy Loans

Policy loans allow a policyholder to borrow money using the policy’s cash value as collateral. The policy remains in force, and interest accrues on the borrowed amount, similar to a traditional loan. Policyholders are not typically required to repay these loans, but any outstanding loan balance, including accrued interest, reduces the death benefit paid to beneficiaries. If a loan is not repaid and its balance, along with interest, grows to exceed the policy’s cash value, the policy could lapse, potentially triggering a taxable event.

Cash Withdrawals

Cash withdrawals involve directly taking funds out of the policy’s cash value. Unlike loans, withdrawals permanently reduce the policy’s cash value and can also decrease the death benefit proportionally. If a significant amount is withdrawn, it could lead to insufficient cash value to cover policy costs, which may cause the policy to lapse. Withdrawals are typically treated under a “first-in, first-out” (FIFO) rule for tax purposes, meaning the portion representing premiums paid is generally tax-free, while any amount exceeding the premiums paid (gains) may be taxable.

Policy Surrender

Policy surrender involves canceling the life insurance policy entirely to receive its cash surrender value. This option provides the policyholder with the largest immediate payout from the policy’s internal value, but it results in the complete termination of the insurance coverage. Insurers may also impose surrender charges, especially if the policy is canceled within the first 10 to 15 years, which can reduce the amount received.

Selling Your Life Insurance Policy

Policyholders can also sell their life insurance policy to a third party. These options, known as viatical settlements and life settlements, provide a lump sum payment in exchange for ownership of the policy.

Viatical Settlements

Viatical settlements are specifically designed for policyholders who are terminally or chronically ill. In this arrangement, a third party purchases the policy for a lump sum, which is typically more than the policy’s cash surrender value but less than the full death benefit. The buyer then becomes the new owner of the policy, assumes responsibility for paying future premiums, and receives the death benefit when the insured passes away. This option provides terminally or chronically ill individuals with immediate funds that can be used for medical expenses, living costs, or to improve their quality of life.

Life Settlements

Life settlements generally apply to policyholders who are typically older or have a change in health, but are not terminally ill. Life settlements involve selling an existing life insurance policy to a third-party investor. This option can be suitable for individuals who no longer need or want their policy, can no longer afford the premiums, or wish to convert an unwanted policy into liquid assets.

Tax Implications of Accessing Life Insurance Funds

Understanding tax implications is important when accessing life insurance funds. The tax treatment varies significantly depending on the method chosen for accessing the policy’s value.

Policy Loans

Policy loans are generally not considered taxable income as long as the policy remains in force. This tax-free status applies as long as the loan amount does not exceed the total premiums paid into the policy. However, if the policy lapses or is surrendered with an outstanding loan, the loan amount, to the extent it represents a gain in the policy, can become taxable as ordinary income. If the policy is classified as a Modified Endowment Contract (MEC), loans and withdrawals may be subject to different tax rules, where any gain is taxed first, and withdrawals may incur a 10% penalty if the policyholder is under age 59½.

Cash Withdrawals

Cash withdrawals are typically treated on a “first-in, first-out” (FIFO) basis for tax purposes. The amount withdrawn up to the total premiums paid into the policy (known as the cost basis) is generally received tax-free, as it is considered a return of principal. Any amount withdrawn that exceeds this cost basis is usually considered a gain and is taxable as ordinary income.

Policy Surrender

When a policy is surrendered, any amount received in excess of the policy’s cost basis (total premiums paid) is generally taxable as ordinary income. This gain is taxed at the policyholder’s applicable income tax rate, not as capital gains. Surrender charges, while reducing the payout, do not alter the tax treatment of the gain.

Viatical Settlements

Viatical settlements are typically structured to be tax-free for terminally ill individuals. Under federal law, if a medical professional certifies that the insured has a life expectancy of 24 months or less, the proceeds from a viatical settlement are generally excluded from taxable income. For chronically ill individuals, viatical settlement proceeds can also be tax-free, provided the funds are used for qualified long-term care expenses.

Life Settlements

Life settlements, unlike viatical settlements, are generally taxable transactions. The proceeds are typically taxed in a tiered manner. The portion of the payout equal to the policy’s cost basis (total premiums paid) is received tax-free. Any amount received above the cost basis, up to the policy’s cash surrender value, is taxed as ordinary income. Any remaining proceeds, specifically those exceeding both the cost basis and the cash surrender value, are taxed as capital gains.

Initiating Your Chosen Transaction

After evaluating options and deciding on a course of action, the next step is initiating the transaction. The administrative process will vary depending on whether the policyholder is accessing funds directly from the insurer or selling the policy to a third party.

For policy loans, cash withdrawals, or policy surrenders, the policyholder should begin by contacting their life insurance company directly. The insurer will provide the necessary forms and detailed instructions specific to the policy. These forms typically require information such as the policy number, the requested amount, and the desired method of fund disbursement.

When pursuing a viatical or life settlement, the process involves engaging with a licensed life settlement provider or broker. These entities will guide the policyholder through their specific application process, which often includes submitting medical records and policy documentation for evaluation. The settlement company will then make an offer based on various factors, including the policy’s value and the insured’s health status.

After completing the required paperwork, the forms can typically be submitted via mail or through the insurer’s or broker’s secure online portal. Processing times can vary; for instance, withdrawals and loans from an insurer might be processed within 14 to 60 days. Life and viatical settlements can take longer, potentially up to a few months, due to the comprehensive review and transfer of ownership involved. Upon approval, funds are disbursed according to the chosen method, such as direct deposit or check.