How to Withdraw From a Life Insurance Policy

Life insurance policies that accumulate cash value offer a distinct financial component beyond their primary death benefit. These policies allow a portion of the premiums paid to grow over time, creating an accessible savings feature. This accumulated value can serve as a financial resource for policyholders during their lifetime, and understanding how to access it can be beneficial for various financial needs.

Types of Life Insurance with Cash Value

Life insurance policies fall into two main categories: term life and permanent life insurance. Term life insurance provides coverage for a specific period and does not build cash value. In contrast, permanent life insurance policies are designed to last for the policyholder’s entire life and include a cash value component that grows over time. Three common types of permanent life insurance policies that build cash value are Whole Life, Universal Life, and Variable Universal Life.

Whole Life Insurance

Whole Life insurance is a type of permanent policy where the cash value grows at a guaranteed interest rate. A portion of each premium payment is allocated to this cash value account, which increases predictably over the policy’s lifetime. This type of policy offers level premiums that remain fixed, providing stability for financial planning.

Universal Life (UL) Insurance

Universal Life (UL) insurance provides flexibility regarding premium payments and the death benefit. The cash value in a UL policy grows based on interest rates set by the insurer, which often include a guaranteed minimum rate. Policyholders can adjust their premium payments within certain limits. A portion of the premium covers the cost of insurance and administrative fees, with the remainder contributing to the cash value account.

Variable Universal Life (VUL) Insurance

Variable Universal Life (VUL) insurance offers potential for cash value growth. In a VUL policy, the cash value is invested in various sub-accounts, similar to mutual funds, chosen by the policyholder. This allows the cash value to grow based on the performance of these investments, offering higher growth potential but also carrying investment risk. Policyholders can adjust premium payments and death benefits, but must monitor investment performance regularly.

Methods of Accessing Policy Value

Policyholders with life insurance policies that accumulate cash value have several ways to access these funds during their lifetime. Each method involves distinct mechanics and affects the policy differently.

Policy Loan

One common method is taking a policy loan. This involves borrowing funds directly from the insurance company, using the policy’s accumulated cash value as collateral. The loan amount does not remove money from the cash value account itself, which continues to earn interest or dividends. However, interest does accrue on the loan, and any outstanding loan balance, including accrued interest, will reduce the death benefit paid to beneficiaries.

Partial Withdrawals

Another way to access cash is through partial withdrawals, sometimes referred to as partial surrenders. This involves directly taking a portion of the accumulated cash value from the policy. Unlike a loan, a withdrawal permanently reduces the policy’s cash value. This reduction in cash value directly leads to a proportional decrease in the policy’s death benefit, diminishing its overall value and future payout.

Full Surrender

Finally, a policyholder can choose to fully surrender their life insurance policy. Surrendering means canceling the policy entirely, at which point the insurance company pays out the cash surrender value. The cash surrender value is the accumulated cash value minus any applicable surrender charges or outstanding loans. Once a policy is surrendered, coverage terminates, and the action is irreversible.

Tax and Policy Implications

Accessing the cash value of a life insurance policy carries specific tax and policy implications that vary by the method chosen. Understanding these consequences is important for informed financial decisions. The tax treatment often hinges on the policy’s cost basis, which is the total amount of premiums paid into the policy.

Policy Loans

Policy loans are not considered taxable income as long as the policy remains in force. This is because the funds are treated as a loan against the policy’s value, not a distribution of earnings. However, if the policy lapses or is surrendered with an outstanding loan, the loan amount exceeding the policy’s cost basis can become taxable as ordinary income. This scenario transforms the tax-free loan into a taxable event.

Partial Withdrawals

When a policyholder takes a partial withdrawal, the funds received are treated as a return of the premiums paid (cost basis) first. This portion of the withdrawal is tax-free. Any amount withdrawn that exceeds the policy’s cost basis is considered a gain and is subject to taxation as ordinary income. For example, if $10,000 in premiums have been paid and $12,000 is withdrawn, the first $10,000 is tax-free, and the remaining $2,000 is taxable income. Partial withdrawals reduce the policy’s cash value and death benefit.

Surrendering a Policy

Surrendering a life insurance policy means terminating the contract, and any amount received above the policy’s cost basis is taxable as ordinary income. For instance, if a policyholder paid $20,000 in premiums and receives a cash surrender value of $30,000, the $10,000 gain is taxable. Insurers may also impose surrender charges, especially if the policy is surrendered within the first 10 to 15 years, reducing the amount the policyholder receives. These charges decrease over time and may disappear after a certain period.

Modified Endowment Contracts (MECs)

Certain policies, if they accumulate cash value too quickly relative to their death benefit, may be classified as Modified Endowment Contracts (MECs) under Internal Revenue Code Section 7702. If a policy becomes an MEC, withdrawals and loans are treated differently for tax purposes. For MECs, distributions (including loans and withdrawals) are taxed on a “last-in, first-out” (LIFO) basis, meaning earnings are considered to be distributed first and are taxable. Additionally, withdrawals from an MEC made before age 59½ may be subject to a 10% early withdrawal penalty, in addition to ordinary income tax on the earnings.

The Withdrawal Process

Initiating a policy loan, partial withdrawal, or surrender requires specific steps. The process begins by contacting the insurer through their customer service channels, which include phone support, online portals, or communication with a dedicated financial advisor. Many companies offer online access to policy details and self-service options, which can expedite the initial inquiry.

Documentation

Once contact is established, the insurer will outline the requirements for the chosen transaction. Policyholders will need to provide their policy number, personal identification such as a driver’s license or state ID, and bank account details for direct deposit of funds. For a policy surrender, a “Surrender Discharge Form” is required. Depending on the insurer and the type of transaction, additional documentation may be necessary. This can include a copy of the original policy document or a voided check to verify banking information for electronic fund transfers. Some insurers may also require additional forms for electronic deposits. Accurately completing all required forms and providing precise information helps avoid delays.

Processing Time

After submitting the necessary forms and documentation, the insurance company will process the request. The processing time can vary, ranging from one to two weeks for policy loans. For partial withdrawals or full surrenders, the timeline might extend from 14 to 60 days, though some straightforward requests can be completed more quickly. Policyholders should expect confirmation of the transaction’s completion and receipt of funds.