How to Take Out Money From Life Insurance

Life insurance provides financial protection to beneficiaries. Some policies offer financial flexibility during the policyholder’s lifetime. They can accumulate cash value, accessible under specific conditions. Utilizing this feature provides liquidity for financial planning. This article explains how to access this accumulated value.

Understanding Cash Value Life Insurance

Cash value life insurance is permanent life insurance that builds a savings component. Premiums contribute to this cash value, which grows tax-deferred. It is enhanced through interest or dividends. The cash value is distinct from the death benefit.

Unlike term life insurance, which has no cash value and covers a specific period, permanent policies remain in force for life. Examples include whole life, universal life, and variable universal life policies. They offer a dual benefit: a death benefit and accessible cash value. The cash value is a financial resource accessible during their lifetime.

Methods for Accessing Your Policy’s Value

Policyholders can access cash value in policies through several methods. Each method impacts the policy’s future and death benefit. Understanding these options aids informed financial decisions.

A policy loan allows the policyholder to borrow money directly from the insurer. The policy remains in force, but the loan amount plus interest reduces the death benefit if not repaid. Policy loans are not considered taxable income. Interest rates vary.

Cash withdrawals are another option. A withdrawal reduces the policy’s cash value and decreases the death benefit. Withdrawals are tax-free up to the policy’s “cost basis,” the total premiums paid. Any amount withdrawn exceeding this cost basis is taxable as ordinary income.

Policy surrender cancels the life insurance policy for its cash surrender value. This terminates death benefit coverage, and the insurer pays out the cash value, minus surrender charges or outstanding loans. Surrendering a policy means losing life insurance coverage, with long-term financial implications.

Accelerated Death Benefits (ADBs), also known as living benefits, allow access to a portion of the death benefit while the insured is still alive, under specific circumstances. These include:
Terminal illness with a life expectancy of 12 to 24 months.
Chronic illness requiring assistance with daily activities.
Critical illness such as a heart attack or stroke.
The amount received reduces the death benefit. Eligibility criteria and the percentage of the death benefit accessible vary by policy and insurer.

Tax Implications of Accessing Funds

Accessing funds carries tax implications. Tax treatment differs depending on the method chosen. Policy loans are not considered taxable income, as they are treated as a debt. However, if a policy with an outstanding loan lapses or is surrendered, the unpaid loan amount, to the extent it exceeds the policy’s cost basis, becomes taxable as ordinary income.

Cash withdrawals are tax-free up to the policy’s cost basis. Cost basis is the total premiums paid, less prior tax-free withdrawals. Any portion of a withdrawal exceeding this cost basis is considered taxable income, representing accumulated earnings.

When a policy is surrendered, the difference between cash surrender value and cost basis is taxable as ordinary income. For example, if a policyholder paid $50,000 in premiums (cost basis) and receives a cash surrender value of $70,000, the $20,000 gain would be subject to income tax. This tax liability may be substantial with significant earnings.

Accelerated Death Benefits (ADBs) are tax-free if health conditions are met. For terminal illness with limited life expectancy, payouts are excluded from gross income. For chronic illness, payouts are tax-free if the insured meets specific criteria, such as being unable to perform two out of six activities of daily living.

A Modified Endowment Contract (MEC) alters life insurance tax treatment. A policy becomes an MEC if cash value accumulates too quickly, failing an IRS “7-pay test.” Once classified as an MEC, withdrawals and loans are taxed on a “Last-In, First-Out” (LIFO) basis, meaning earnings are taxed first. Additionally, MEC withdrawals and loans before age 59½ are subject to a 10% penalty tax, similar to early retirement plan withdrawals.

Steps to Access Your Life Insurance Funds

Accessing funds begins with contacting the insurance provider or financial advisor. This allows discussion of needs and determination of the most suitable method (loan, withdrawal, or surrender).

Upon contacting the insurer, policyholders will need to provide information. This includes:
Policy number
Full legal name
Date of birth
Last four digits of their Social Security number
Having this information available expedites the inquiry.

The insurer provides necessary forms. Forms require details like desired amount, disbursement method (e.g., direct deposit, check), and confirmation of understanding implications. Review them carefully, as they outline terms and conditions.

Once completed, forms must be submitted to the insurer through designated channels (mail, fax, or online portal). Some insurers require original signatures, while others accept electronic submissions. Processing time varies, from days to weeks, depending on complexity. Following up can help track progress and address delays.