Should I Cancel My Life Insurance Policy?

Considering the cancellation of a life insurance policy is a complex decision. Life insurance serves as a financial safeguard for dependents, providing a death benefit that can help cover expenses and maintain financial stability after an unexpected loss. However, personal circumstances, financial priorities, and long-term planning evolve, prompting policyholders to re-evaluate their coverage needs. This article clarifies factors, financial implications, and alternatives to outright cancellation.

Key Policy Features and Types

Life insurance policies fall into two main categories: term and permanent life insurance. Term life insurance provides coverage for a specific period, such as 10, 20, or 30 years, and pays a death benefit if the insured passes away within that term. This type of policy does not accumulate cash value and is often more affordable for temporary financial needs. At the end of the specified term, coverage ceases unless the policy is renewed or converted.

Permanent life insurance provides lifelong coverage as long as premiums are paid. This category includes policies like whole life, universal life, and variable universal life. Permanent policies have a cash value component that grows tax-deferred. This savings element can be accessed during the policyholder’s lifetime.

Cash value accumulates from a portion of each premium payment and earns interest. It can be used for loans, withdrawals, or paying future premiums. Understanding if your policy has cash value is fundamental, as it significantly impacts the financial outcomes of cancellation.

Financial Considerations of Cancelling

Canceling a life insurance policy, especially a permanent one with cash value, involves financial considerations. Upon cancellation, the policyholder may receive the cash surrender value, which is accumulated cash value minus surrender charges. Surrender charges are fees for early termination, typically within the first 10 to 15 years. These charges can be substantial initially, sometimes 10% of cash value, and decrease over time.

Cancellation immediately results in loss of the death benefit. Beneficiaries lose financial protection. For cash value policies, any amount received above total premiums paid is taxable income. The Internal Revenue Service (IRS) views return of premiums as tax-free, but any gain is taxed as ordinary income.

For example, if $50,000 in premiums were paid and $60,000 received as cash surrender value, the $10,000 gain is subject to ordinary income tax. The insurance company issues Form 1099-R for taxable distributions. While a cash payout may seem appealing, understand potential tax liabilities and surrender charge reductions.

Exploring Alternatives to Cancellation

Before canceling, explore alternatives that align with evolving financial needs without sacrificing coverage.

• Reduce the policy’s coverage amount (face value). This lowers premiums, making the policy more affordable while retaining protection. This is useful if the need for a high death benefit has diminished, such as after a mortgage is paid off or children become financially independent.
• Convert term life to permanent life insurance. Many term policies allow conversion to a permanent policy without a new medical examination. This is valuable if health has changed, securing lifelong coverage that might otherwise be difficult or expensive. The new permanent policy will likely have higher premiums due to its cash value and lifelong nature.
• Access cash value through policy loans or withdrawals. A policy loan allows borrowing against cash value, using the policy as collateral. Loans accrue interest; if not repaid, the balance and interest reduce the death benefit. Withdrawals reduce cash value and death benefit; while generally tax-free up to premiums paid, gains can be taxable.
• Consider a life settlement. This involves selling the policy to a third party for a cash sum, typically more than cash surrender value but less than the death benefit. The buyer takes over premiums and receives the death benefit upon the insured’s passing. Life settlement proceeds can be taxable: amounts up to cost basis are tax-free, amounts between cost basis and cash surrender value are ordinary income, and remaining proceeds are capital gains.

Making an Informed Decision

Deciding whether to cancel a life insurance policy requires evaluating current and future financial circumstances. Revisit original reasons for purchasing the policy and assess if needs still exist or have changed. For example, if dependents are independent or major debts are paid, the initial need for coverage may have diminished.

Consider your health and age, as new coverage later in life, especially with health issues, can be more expensive or impossible. Evaluate if premium burden outweighs benefits of maintaining coverage for future needs. A comprehensive review of your financial planning goals is essential.

Assess how the policy fits into your estate plan, retirement strategy, and long-term financial security for loved ones. The decision should be part of a broader financial assessment. Understanding the implications of each alternative, from reducing coverage to a life settlement, allows for a choice that supports your financial well-being and protects beneficiaries.