How to Get Cash Value From Life Insurance

Cash value life insurance offers a financial component accessible during a policyholder’s lifetime, distinguishing it from term life insurance. This article explains the nature of life insurance cash value, methods for accessing it, and associated tax and policy implications.

Understanding Life Insurance Cash Value

Cash value is a component of permanent life insurance policies that grows over time. It represents a portion of the premiums paid into the policy, which, along with interest or investment gains, accumulates separately from the death benefit. This accumulation creates a savings or investment element within the insurance contract itself.

The way cash value accumulates varies by policy type. Whole life insurance policies typically offer a guaranteed interest rate, providing predictable growth and a stable cash value. Universal life insurance policies offer more flexibility, with cash value growth influenced by current interest rates, though they often include a guaranteed minimum rate. Variable universal life insurance allows policyholders to allocate cash value into investment subaccounts, offering potential for higher returns but also greater risk as the value can fluctuate with market performance. Indexed universal life insurance ties cash value growth to a market index, providing some market participation while often including downside protection.

A portion of each premium payment is allocated to the cost of insurance, while another part contributes to the cash value. This cash value grows on a tax-deferred basis, meaning taxes on the gains are not typically owed until the money is withdrawn or the policy is surrendered. The accumulated cash value can be used for various purposes, such as covering future expenses or serving as collateral for loans.

Methods for Accessing Cash Value

Policyholders have several methods for accessing the cash value accumulated within their permanent life insurance policies, including policy loans, withdrawals, and full policy surrenders.

One common method is taking a policy loan. The loan amount is secured by the policy’s cash value, meaning no credit check is usually required. The insurer will provide the funds, and the policyholder then repays the loan over time, often with interest. The maximum loan amount is usually a percentage of the cash value, such as up to 90% or 95%.

Another way to access funds is through withdrawals, sometimes referred to as partial surrenders. This process involves requesting a specific amount of money directly from the policy’s cash value. The requested amount is then deducted from the cash value, reducing it directly.

The third method is a full policy surrender, which involves terminating the entire life insurance contract. The insurer then calculates the cash surrender value, which is the cash value minus any applicable surrender charges and outstanding loans or fees. Upon completion, the policyholder receives this net amount, and the life insurance coverage ceases entirely.

Tax Considerations for Cash Value Access

Accessing life insurance cash value carries distinct tax implications, which vary depending on the method used. Understanding these can help policyholders avoid unexpected tax liabilities.

Policy loans are generally not considered taxable income as long as the life insurance policy remains in force. This is because the Internal Revenue Service (IRS) views a policy loan as a loan against an asset, not a distribution of income. However, if the policy lapses or is surrendered with an outstanding loan, the unpaid loan amount, to the extent it exceeds the policy’s cost basis, may become taxable as ordinary income. Interest paid on policy loans is typically not tax-deductible for personal use.

Withdrawals from a cash value policy are generally tax-free up to the policy’s cost basis. The cost basis represents the total amount of premiums paid into the policy, reduced by any prior tax-free distributions or dividends received. Any amounts withdrawn that exceed this cost basis are typically taxed as ordinary income.

When a policy is fully surrendered, the difference between the cash surrender value received and the policy’s cost basis is generally taxable as ordinary income. For instance, if a policyholder paid $50,000 in premiums (cost basis) and receives $70,000 upon surrender, the $20,000 gain would be taxable. The insurance company may issue a Form 1099-R for the taxable portion of the surrender value.

A Modified Endowment Contract (MEC) status significantly alters the tax treatment of cash value access. A policy becomes an MEC if the premiums paid exceed certain IRS limits within the first seven years, known as the “seven-pay test.” Once designated as an MEC, withdrawals and loans are taxed on a “last-in, first-out” (LIFO) basis, meaning gains are considered distributed first and are taxable as ordinary income. Additionally, distributions from an MEC before age 59½ may be subject to a 10% federal penalty tax, similar to rules for qualified retirement plans.

Policy Implications of Cash Value Access

Accessing cash value impacts the policy itself, affecting the death benefit, longevity, and future premium requirements.

Taking a policy loan directly reduces the death benefit that will be paid to beneficiaries. If the loan, plus any accrued interest, is not repaid before the insured’s death, the outstanding balance is subtracted from the death benefit. Continuous accumulation of loan interest can further erode the cash value, potentially leading to the policy lapsing if the loan balance grows to exceed the available cash value. A policy lapse due to an outstanding loan would terminate coverage and could trigger a taxable event on the loan amount.

Withdrawals from the cash value also have immediate effects on the policy. The cash value of the policy is directly reduced by the amount taken, leading to a corresponding decrease in the policy’s death benefit. Depending on the policy structure and the size of the withdrawal, this action could necessitate increased future premium payments to maintain the desired death benefit or prevent the policy from lapsing prematurely.

A full policy surrender completely terminates life insurance coverage. When a policy is surrendered for its cash value, the death benefit is eliminated entirely, meaning beneficiaries will receive no payout upon the insured’s death. This action ends the contractual agreement with the insurer, relieving the policyholder of future premium obligations but also removing the life insurance protection.