Should I Cash In My Life Insurance Policy?

Cashing in a life insurance policy refers to the act of surrendering the policy to the issuing insurance company in exchange for its accumulated cash value. Individuals may consider this option for various financial needs or if they no longer require coverage. Understanding the implications involves recognizing how its cash value is determined, what deductions may apply, and the potential tax consequences.

Understanding Policy Cash Value

Cash value represents a savings component within certain types of life insurance policies. This value accumulates over time, distinct from the death benefit paid to beneficiaries upon the insured’s passing. A portion of each premium payment contributes to this cash value, which then typically grows on a tax-deferred basis through interest earnings or investment returns, after accounting for policy charges.

The accumulation method and guarantees vary depending on the policy type. Whole life insurance policies feature a guaranteed cash value that grows at a fixed interest rate, providing predictable accumulation. Universal life insurance policies offer more flexibility, with cash value growth often tied to current interest rates, though some may include a guaranteed minimum rate. Variable universal life policies allow the cash value to be invested in sub-accounts, similar to mutual funds, meaning its growth or decline is linked to market performance and carries greater risk and potential reward. In contrast, term life insurance policies do not build cash value and therefore do not offer a surrender option.

For policies that do accumulate cash value, it generally takes several years for a substantial amount to build. The growth of cash value can be influenced by the amount of premiums paid, the policy’s duration, and the size of the death benefit.

Calculating Your Payout

The amount received when surrendering a life insurance policy is the cash surrender value, which differs from the policy’s stated cash value. The cash surrender value represents the total accumulated cash value, but with certain deductions applied.

One significant deduction is surrender charges. These fees are imposed by the insurance company for terminating a policy before a specified period, often within the first 10 to 15 years of the policy’s inception. These charges usually start at a higher percentage, potentially around 10% in the first year, and then gradually decrease over time until they eventually phase out.

Any outstanding policy loans taken against the cash value, along with accrued interest on those loans, will also be subtracted from the payout. Additionally, any unpaid premiums or administrative fees due at the time of surrender might reduce the final amount. Policyholders can typically find specific details regarding their cash surrender value and applicable charges by contacting their insurance company or reviewing their policy statements.

Tax Considerations

Surrendering a life insurance policy can have important tax implications, which policyholders must understand before making a decision. Generally, the portion of the cash surrender value that exceeds the policy’s cost basis is considered taxable income. The “cost basis” of a life insurance policy is typically the total amount of premiums paid into the policy, minus any previous tax-free withdrawals.

If the cash surrender value received is greater than the total premiums paid, the excess amount is usually taxed as ordinary income. For instance, if $20,000 in premiums were paid and the cash surrender value is $25,000, the $5,000 gain would generally be subject to income tax. However, if a policy is surrendered with an outstanding loan, and the loan amount plus any other distributions exceed the policy’s cost basis, the excess may become taxable. An important consideration involves Modified Endowment Contracts (MECs). A life insurance policy becomes an MEC if the premiums paid exceed certain IRS limits, specifically failing the “7-pay test” within the first seven years. Once a policy is classified as an MEC, it permanently loses some of the favorable tax treatments typically associated with life insurance. Withdrawals and loans from an MEC are taxed on a “last-in, first-out” (LIFO) basis, meaning gains are considered withdrawn first and are subject to ordinary income tax. Furthermore, if distributions from an MEC are taken before the policyholder reaches age 59½, a 10% federal penalty tax may apply to the taxable gains, similar to early withdrawals from retirement accounts. Individuals should consult with a qualified tax professional for personalized advice regarding their specific policy and financial situation.

Cashing Out Your Policy

Cashing out a life insurance policy is an administrative process. The initial step involves contacting the insurance company that issued the policy. This can typically be done through their customer service line, website, or by reaching out to a local agent. The insurer will provide the necessary forms and specific instructions for surrendering the policy.

Commonly required documentation includes a completed surrender form, which often requires the policy number, the policyholder’s signature, and sometimes notarization. Identity verification documents, such as a copy of a government-issued ID and proof of address, are also typically requested to prevent fraud. The original policy document is frequently required, or an indemnity bond may be needed if the original is lost. Additionally, bank account details, usually in the form of a cancelled check or a recent bank statement, are needed to facilitate the direct deposit of funds.

After submitting all required forms and documentation, the insurance company will review the request. The timeframe for processing a surrender request and disbursing funds can vary, but it typically ranges from 14 to 60 days. Once the transaction is complete, the policy ceases to exist, meaning all coverage terminates and no death benefit will be paid. It is advisable to retain copies of all submitted documents and the confirmation of policy termination for personal records.