Should I Cash In My Whole Life Insurance Policy?

Whole life insurance is a type of permanent life insurance that provides coverage for an individual’s entire life. Unlike term insurance, it includes a savings component known as cash value. This cash value accumulates over time on a tax-deferred basis, with earnings not taxed until withdrawn. Policyholders may access this cash value as a financial resource during their lifetime. Understanding the mechanics and implications of accessing this value is important for making informed financial decisions.

Understanding Your Policy’s Value and Options

A whole life insurance policy builds a guaranteed cash value that increases steadily over its lifetime at a set interest rate. Participating policies can also grow through dividends, though dividends are not guaranteed. This cash value component provides a living benefit in addition to the death benefit.

When considering the value of your policy, it is important to distinguish between the accumulated cash value (ACV) and the cash surrender value (CSV). The ACV represents the total cash value that has accrued in the policy, including guaranteed growth and any dividends. The CSV, on the other hand, is the amount a policyholder would receive if they were to terminate the policy, after any applicable surrender charges and outstanding policy loans are deducted.

Policyholders have several ways to access the cash value without fully surrendering the policy. One common method is taking a policy loan, where you borrow money from the insurer using your policy’s cash value as collateral. These loans typically do not require credit checks and have flexible repayment schedules, though interest accrues on the outstanding balance. An unpaid loan balance, including accrued interest, will reduce the death benefit paid to beneficiaries if the insured passes away before repayment.

Another option is making a partial withdrawal from the cash value. Unlike a loan, a withdrawal permanently reduces both the policy’s cash value and its death benefit. Withdrawals are generally treated as tax-free up to the amount of premiums paid into the policy, which is considered a return of your cost basis. However, any amount withdrawn that exceeds the total premiums paid may be subject to ordinary income tax.

Policyholders can also utilize non-forfeiture options, which allow them to stop paying premiums while retaining some value from the policy. One such option is reduced paid-up insurance, where the accumulated cash value is used to purchase a smaller, fully paid-up whole life policy. This new policy will have a reduced death benefit but requires no further premium payments.

Alternatively, extended term insurance is a non-forfeiture option where the cash value is used to purchase a term life insurance policy for the original face amount for a specific period. The length of this term depends on the available cash value. This option provides the full death benefit for a limited time without additional premiums, but the coverage eventually expires.

Financial and Tax Considerations of Surrender

Fully surrendering a whole life insurance policy involves terminating coverage and receiving the cash surrender value. This action has significant financial and tax implications, including the immediate cessation of the death benefit.

A primary tax consideration when surrendering a policy is the potential for a taxable gain. This gain is calculated as the cash surrender value received minus the total premiums paid into the policy, which is considered your cost basis. This gain is typically taxed as ordinary income.

Certain policies may be classified as Modified Endowment Contracts (MECs), which have more stringent tax rules. A policy becomes a MEC if the premiums paid exceed specific IRS limits, known as the “7-pay test,” within the first seven years of the policy’s existence. Once a policy is designated as a MEC, this classification is permanent and irreversible.

The tax treatment of distributions from a MEC differs significantly from a non-MEC policy. Withdrawals and loans from a MEC are subject to “Last-In, First-Out” (LIFO) taxation, meaning that any earnings are considered to be withdrawn first and are fully taxable as ordinary income. Additionally, if the policyholder is under age 59½, these taxable distributions from a MEC may be subject to a 10% federal penalty tax, similar to early withdrawals from qualified retirement plans.

Before receiving the cash surrender value, the insurance company will typically deduct any applicable surrender charges. These charges are fees imposed by the insurer for early termination of the policy and are usually highest in the initial years of the policy, gradually decreasing over time. Surrender charges can significantly reduce the net amount received by the policyholder.

Finally, surrendering a whole life policy also removes it from the policyholder’s estate. The policy’s value, which would have been paid as a tax-free death benefit to beneficiaries, is now received by the policyholder and could be subject to income tax. Policyholders should also consider any outstanding loans, as an unpaid loan balance at the time of surrender will be deducted from the cash surrender value and may become taxable if the policy’s basis has been exceeded.

The Process of Policy Surrender

The process of surrendering a whole life insurance policy involves several procedural steps. First, contact the issuing insurance company directly through their customer service phone line, their official website, or by reaching out to your insurance agent.

Request the specific forms required for a policy surrender, typically referred to as a “Surrender Request Form” or “Cash Surrender Form.” This form serves as the official instruction to the insurer to terminate the policy and disburse the available cash value. The form will require specific information, including the policy number, the policyholder’s full legal name, current contact information, and details regarding the desired method of payment. Providing accurate and complete information helps prevent delays in processing.

In addition to the completed form, the insurance company may require supporting documentation. Common requirements include proof of identity, such as a copy of a driver’s license or state ID, and a voided check if direct deposit is the preferred payment method. All policy owners are typically required to sign the surrender form, and in many instances, these signatures may need to be notarized or require a signature guarantee from a financial institution to verify their authenticity.

Once the form and necessary documentation are gathered, submit them to the insurance company. Submission methods vary by insurer and may include mailing the documents to a specific address, uploading them through an online portal if available, or submitting them in person at a company office. Using a trackable shipping method for mailed documents is advisable.

The processing time for a policy surrender can vary, but it generally takes several business days to a few weeks for the insurance company to review the request, process the payment, and issue the funds. After the request is processed, the insurer should provide confirmation that the policy has been terminated and that the final payment has been issued.

Finally, if a taxable gain resulted from the surrender of the policy, the insurance company is legally obligated to report this to the Internal Revenue Service (IRS). The insurer will typically issue a Form 1099-R to the policyholder for tax reporting purposes in the year the surrender occurred.