If You Have Life Insurance, Can You Take Money Out?

Life insurance policies can provide a financial safety net for loved ones. Some types of policies also offer the ability to access funds during the policyholder’s lifetime. This possibility depends on the kind of life insurance coverage in place.

Understanding Cash Value Life Insurance

Certain life insurance policies build cash value, a savings component within the policy. This cash value grows over time on a tax-deferred basis, meaning earnings are not taxed until withdrawn or the policy is surrendered. A portion of each premium payment contributes to this cash value, alongside the cost of insurance and administrative fees.

Policies that accumulate cash value include Whole Life, Universal Life, and Variable Universal Life. Whole Life insurance offers fixed premiums and a guaranteed cash value growth rate, alongside a guaranteed death benefit. Universal Life policies provide more flexibility, allowing adjustments to premium payments and the death benefit, with cash value growth tied to current interest rates. Variable Universal Life policies offer greater flexibility, as the cash value is invested in sub-accounts chosen by the policyholder, exposing it to market fluctuations and potential for higher growth or loss. In contrast, term life insurance policies only provide coverage for a specific period and do not build cash value, meaning there are no funds to access from this type of policy.

Methods for Accessing Cash Value

Policyholders have several distinct methods for accessing the accumulated cash value within their life insurance policies. Each method carries different implications for the policy and its beneficiaries.

One common way to access funds is through a policy loan. When a policyholder takes a loan, they are borrowing money from the insurer, using the policy’s cash value as collateral. The policy remains in force, and the loan accrues interest, typically at a variable rate set by the insurance company. If the loan and accrued interest are not repaid, the outstanding amount will reduce the death benefit paid to beneficiaries. Should the loan balance, including interest, grow to exceed the policy’s cash value, the policy could lapse, triggering potential tax consequences.

Another method is taking cash withdrawals directly from the policy’s cash value. Unlike a loan, a withdrawal permanently removes funds from the policy. This action directly reduces the policy’s cash value and the death benefit. Withdrawals do not accrue interest, but the amount removed is no longer available to grow within the policy.

The final way to access cash value is by surrendering the policy. Policy surrender involves terminating the life insurance coverage entirely. Upon surrender, the policyholder receives the cash surrender value, which is the accumulated cash value minus any outstanding loans and applicable surrender charges.

Tax Considerations of Accessing Funds

Accessing funds from a life insurance policy’s cash value involves important tax considerations that vary by the method chosen. Understanding these implications is crucial for managing personal finances effectively.

Policy loans are generally not considered taxable income because they are treated as debt. However, this tax-free status can change if the policy lapses or is surrendered with an outstanding loan. In such cases, the unpaid loan amount, up to the amount of gain in the policy, may become taxable as ordinary income, resulting in an unexpected tax liability.

Cash withdrawals are typically tax-free up to the amount of premiums paid into the policy, known as the “cost basis.” Any amount withdrawn that exceeds this cost basis is considered taxable income and is taxed at ordinary income rates. This “gain” represents the earnings that have accumulated within the policy.

When a policy is surrendered, the difference between the cash surrender value received and the total premiums paid (the cost basis) is taxable as ordinary income. If the cash surrender value is less than the total premiums paid, no taxable gain occurs.

A special consideration arises with Modified Endowment Contracts (MECs). These are life insurance policies overfunded according to Internal Revenue Code guidelines. Once classified as an MEC, loans and withdrawals are taxed differently; they are subject to the “last-in, first-out” (LIFO) rule, meaning any gains are considered withdrawn first and are therefore taxable. Additionally, distributions from an MEC, including loans and withdrawals, made before the policyholder reaches age 59½ may be subject to a 10% federal income tax penalty, similar to distributions from qualified retirement plans.

Impact on Your Life Insurance Policy

Accessing the cash value of a life insurance policy has several non-tax consequences that directly affect the policy’s integrity and future benefits. These impacts extend beyond the immediate financial transaction and can alter the policy’s original purpose.

One direct consequence of both policy loans and cash withdrawals is a reduction in the policy’s death benefit. Any outstanding loan balance, including accrued interest, will be subtracted from the death benefit paid to beneficiaries. Cash withdrawals permanently reduce the policy’s cash value, which in turn diminishes the death benefit by the amount withdrawn.

Another significant impact is the potential for the policy to lapse. Policy loans accrue interest, and if these interest payments are not made, the outstanding loan balance can grow to deplete the policy’s cash value. If the loan plus interest exceeds the cash value, and the policyholder does not make additional payments to cover the shortfall, the policy may terminate. Excessive cash withdrawals can also reduce the cash value to a point where it can no longer support the policy’s internal charges, such as the cost of insurance and administrative fees, leading to policy termination if insufficient funds remain.

If a policy is surrendered, particularly in its early years, surrender charges may apply. These charges are fees imposed by the insurance company for early termination of the contract and are deducted from the cash value when the policy is surrendered. Surrender charges are typically outlined in the policy contract and can significantly reduce the actual cash value received by the policyholder upon surrender.