Should I Surrender My Life Insurance Policy?

Life insurance policies offer financial protection, providing a payout to beneficiaries upon the policyholder’s death. Circumstances can change, leading some policyholders to consider discontinuing coverage. One option is to surrender the policy, formally terminating the contract with the insurer. This decision carries various financial implications.

Understanding Policy Surrender

Surrendering a life insurance policy means formally canceling the contract with the insurance company. For permanent policies, like whole life or universal life, this involves giving up the policy for its cash value. Cash value is a component of permanent life insurance that accumulates over time, functioning as a savings or investment element. A portion of each premium paid contributes to this cash value, which grows tax-deferred.

The amount received when surrendering a policy is the cash surrender value. This value is the accumulated cash value minus any surrender charges and outstanding policy loans. Surrender charges are fees deducted by the insurance company for early termination, typically highest in the first 10 to 15 years and gradually decreasing over time. Term life insurance policies do not build cash value and cannot be surrendered for payment.

Financial Outcomes of Policy Surrender

Surrendering a life insurance policy has direct financial consequences, including the net amount received and potential tax obligations. The net surrender value is the policy’s accumulated cash value minus any surrender charges, outstanding loans, or prior withdrawals. This is the amount the policyholder receives.

Tax treatment of the surrender value is a key consideration. Any amount received exceeding the policy’s “cost basis” is taxable income. The cost basis represents total premiums paid into the policy, reduced by any dividends or prior tax-free withdrawals. This taxable gain is treated as ordinary income, not capital gains, and is subject to the policyholder’s income tax rate. For example, if premiums paid were $20,000 and the net surrender value is $23,000, the $3,000 gain is taxable.

If the policy is a Modified Endowment Contract (MEC), withdrawals or loans from the cash value, including those taken upon surrender, may have different tax rules. MECs are policies that exceeded certain IRS premium limits, losing some tax advantages. For MECs, gains are taxed first, and withdrawals or loans may incur a 10% penalty if the policyholder is under age 59½. Insurers issue a Form 1099-R if a taxable distribution occurs upon surrender, detailing the amount received and the taxable portion.

Deciding Whether to Surrender

Deciding to surrender a life insurance policy requires evaluating personal circumstances and financial needs. Consider the current need for life insurance coverage. If dependents or significant debts, like a mortgage or student loans, no longer exist, the policy’s original purpose might have diminished.

Current health status also plays a role. Obtaining new life insurance later in life, particularly with declining health, can be more expensive or impossible. Assess if immediate financial needs outweigh the long-term benefits of maintaining the policy. Unaffordable premiums can also prompt a policy review. Evaluate if the policy still aligns with overall financial goals and if the cash value could be better utilized elsewhere.

Options Instead of Surrendering

Before surrendering a life insurance policy, several alternatives can help manage an unwanted or unaffordable policy while preserving some benefits.

Policy Loan: Borrow against the accumulated cash value. The cash value serves as collateral, and interest is charged. Any outstanding loan balance reduces the death benefit.
Reduced Paid-Up Option: Uses existing cash value to purchase a smaller, fully paid-up life insurance policy. No further premium payments are required, and a reduced death benefit remains for the policyholder’s lifetime.
Extended Term Option: Utilizes cash value to buy a term life insurance policy for the same death benefit for a limited period, eliminating future premium payments.
Life Settlement: Sell the policy to a third party for a lump sum, which is more than the cash surrender value but less than the death benefit. The buyer assumes premium payments and receives the death benefit.
Viatical Settlement: A specific type of life settlement for individuals with a terminal or chronic illness, often providing a higher percentage of the death benefit and potentially tax-exempt proceeds.
Use Dividends: If a participating policy, use dividends to reduce future premium payments, maintaining coverage without increasing out-of-pocket costs.

Steps to Surrender Your Policy

The process to surrender a life insurance policy is straightforward. First, contact the insurance company directly, either by phone or through their online portal. The insurer will guide you on necessary documentation and procedures.

The insurance company requires a completed surrender form. This form asks for the policy number, policyholder’s signature, and sometimes requires notarization. Proper identification, such as a copy of a driver’s license, may also be requested. Complete all sections accurately to avoid delays.

Provide banking information for direct deposit of the surrender value; a check may be an option. After submitting forms and identification, the insurance company processes the request. Processing time varies, from a few business days to several weeks. Upon completion, the policyholder receives confirmation that the policy has been surrendered and payment issued.