Should I Cash Out My Life Insurance Policy?

Life insurance policies can offer financial protection for beneficiaries after the policyholder’s death, but certain types also include a living benefit component known as cash value. This cash value accumulates over time within permanent life insurance policies, such as whole life, universal life, variable universal life, and indexed universal life insurance. Unlike term life insurance, which covers a specific period, permanent policies last for the insured’s lifetime and build this accessible savings component, which policyholders can access for various needs.

Understanding Your Policy’s Cash Value

A portion of each premium payment on a permanent life insurance policy contributes to its cash value. This means one part covers insurance costs and administrative fees, while another builds the cash component. The cash value grows through guaranteed interest rates, dividends, or investment performance, depending on the policy type. Whole life policies typically offer a guaranteed growth rate, while universal life policies may have growth tied to interest rates or market indexes.

Several factors influence the rate at which cash value accumulates. Policy fees, administrative charges, and the cost of insurance (which increases with age) can affect cash value growth. Insurers also apply surrender charges, particularly in the early years of a policy. These charges are deductions from the cash value if the policy is terminated, designed to recoup the insurer’s upfront costs.

Surrender charges typically decrease over a period, often between 10 to 15 years, eventually phasing out completely. These charges can significantly reduce the accessible cash value, especially if a policy is surrendered prematurely. Policyholders should regularly review their annual statements, which detail the current cash value, any accumulated interest or dividends, and the applicable surrender charges. Contacting the insurer provides specific figures on cash value and fees.

Methods for Accessing Cash Value

Policyholders can access their permanent life insurance policy’s cash value in several ways. Each method involves specific steps and results in different policy handling. One option is to surrender the policy, terminating coverage entirely. To initiate a surrender, the policyholder contacts the insurer, completes a request form, and provides identification. Upon processing, the insurer pays the net cash surrender value (cash value minus outstanding loans, interest, and surrender charges), permanently ending coverage.

Another way to access funds is a partial withdrawal from the cash value. This allows taking a portion of funds without terminating the policy. To make a partial withdrawal, the policyholder submits a request form to the insurer, specifying the amount. This directly reduces the policy’s cash value and proportionally reduces the death benefit. The policy remains in force, but with diminished cash value and death benefit.

A third method is a policy loan, where the policyholder borrows money using the cash value as collateral. This is a loan against the cash value, meaning the policy remains active. Policyholders can request a loan by contacting their insurer and completing an application, often with no credit check. Interest accrues on the outstanding loan balance; any unpaid balance plus accrued interest will reduce the death benefit.

Financial and Tax Implications of Accessing Cash Value

Accessing a life insurance policy’s cash value has financial and tax consequences that vary by method. When a policy is surrendered, any amount exceeding the policyholder’s “cost basis” is generally taxable income. The cost basis refers to total premiums paid into the policy, less any prior tax-free withdrawals. This taxable gain is treated as ordinary income, not capital gains, subject to the policyholder’s regular income tax rate. Surrendering the policy also eliminates the death benefit, meaning no payout to beneficiaries.

For partial withdrawals, the IRS generally applies a “first-in, first-out” (FIFO) rule. Under this rule, withdrawals are considered a return of the cost basis first, which is tax-free up to the amount of premiums paid. Any amounts withdrawn beyond the cost basis are taxable income. Partial withdrawals also reduce the policy’s cash value and death benefit. If a withdrawal significantly depletes cash value, it might affect the policy’s ability to cover internal charges, potentially requiring premium payments to prevent lapse.

Policy loans are generally not taxable income, provided the policy remains in force. This tax-free treatment applies because a loan is a debt against the policy’s value, not a distribution of earnings. However, if the policy lapses or is surrendered with an outstanding loan, the amount exceeding the cost basis may become taxable. An unpaid policy loan, including accrued interest, will reduce the death benefit. While policy loans offer flexibility, excessive borrowing without repayment can erode the death benefit and lead to a taxable event if the policy terminates.

Alternatives to Accessing Cash Value

Instead of cashing out a life insurance policy, several alternatives align with financial goals or changing circumstances. One option is the reduced paid-up option, allowing a policyholder to stop paying premiums while retaining a smaller, fully paid-up policy. The existing cash value purchases a new policy with a reduced death benefit, requiring no further premium payments. This is useful for those who can no longer afford premiums but still desire lifelong coverage.

Another alternative is the extended term option, where the policy’s cash value purchases a term life insurance policy for a specific duration. This option maintains the original death benefit for a set period, without additional premium payments. The new term policy’s length depends on the cash value and the insured’s age. This approach provides continued coverage for a limited time if premiums become a burden.

For policyholders seeking to change coverage without immediate taxation, a 1035 exchange allows tax-free transfer of cash value from one life insurance policy to another, or to an annuity. This strategy benefits those looking to switch insurers or policy types, or convert a life insurance policy into an income stream for retirement. Some policies offer accelerated death benefits, also known as living benefits. These provisions allow policyholders with a terminal or chronic illness to access a portion of their death benefit while alive, typically for medical or long-term care costs. The amount received reduces the final death benefit.

For older or seriously ill policyholders, viatical or life settlements offer another avenue. A viatical settlement involves selling the policy to a third party for a lump sum, typically more than the cash surrender value but less than the full death benefit. The third party assumes premium payments and receives the death benefit when the insured dies. A life settlement is similar but applies to policyholders who are not terminally ill. Other financial solutions, such as personal loans or liquidating other assets, can also be considered.