Types of Life Insurance Policies You Can Cash Out

Life insurance policies can serve a dual purpose, offering both a death benefit for beneficiaries and a living benefit through accumulated cash value. This cash value component, present in certain types of policies, can be accessed by the policyholder during their lifetime. The ability to “cash out” refers to tapping into this growing value, which differentiates these policies from those solely providing a death benefit.

Understanding Cash Value Life Insurance Policies

Cash value life insurance policies are distinct from term life insurance, which provides coverage for a specific period without accumulating any cash value. Permanent life insurance policies, conversely, include a savings component where a portion of each premium payment contributes to a growing cash value. This accumulated cash value can be accessed by the policyholder during their lifetime.

Whole life insurance is a type of permanent policy characterized by fixed premiums, a guaranteed death benefit, and guaranteed cash value growth. A part of each premium payment is allocated to the cash value, which accumulates at a predetermined interest rate, ensuring predictable growth and a stable financial component within the policy.

Universal life insurance policies offer more flexibility, allowing for adjustable premiums and death benefits. The cash value in a universal life policy grows based on an interest rate set by the insurer, often with a guaranteed minimum rate. Premiums cover the cost of insurance and administrative fees, with any remaining amount contributing to the cash value.

Variable universal life (VUL) insurance introduces an investment component, where the cash value fluctuates based on the performance of underlying investment sub-accounts, similar to mutual funds. Policyholders choose how their cash value is invested, offering potential for higher returns but also carrying greater market risk. Premiums cover insurance costs, with the remainder invested in chosen sub-accounts.

Accessing Cash Value While Your Policy is Active

Policyholders have options to access their accumulated cash value while keeping their life insurance policy in force. Two primary methods are taking a policy loan or making a partial withdrawal. Both approaches allow access to funds without terminating coverage, though they have different financial implications.

Policy loans enable policyholders to borrow money directly from the insurer, using the policy’s cash value as collateral. These loans typically do not require a credit check and often have competitive interest rates. While repayment is flexible, any outstanding loan balance, including accrued interest, will reduce the death benefit paid to beneficiaries if the loan is not repaid.

Partial withdrawals allow policyholders to take a portion of their cash value. This action directly reduces both the policy’s cash value and its death benefit. Unlike loans, withdrawals are permanent and do not need to be repaid. Some policies may impose surrender charges on partial withdrawals, especially if taken early in the policy’s life.

Surrendering Your Life Insurance Policy

Surrendering a life insurance policy involves canceling the coverage in exchange for its cash value. This action results in the complete termination of the policy and its death benefit. The amount received is known as the “cash surrender value.”

The cash surrender value is calculated as the accumulated cash value minus any applicable surrender charges, outstanding policy loans, or fees. Surrender charges are typically higher in the initial years and generally decrease over time, often phasing out after 10 to 15 years. These charges are in place to offset the insurer’s upfront costs associated with issuing the policy.

To surrender a policy, the policyholder typically needs to contact their insurance provider and complete a surrender request form. Upon completion of the process, the insurer will issue a payment for the cash surrender value. Once a policy is surrendered, the insurance coverage ends, meaning no death benefit will be paid to beneficiaries in the future.

Tax Implications of Accessing Cash Value

Accessing cash value from a life insurance policy has tax implications depending on the access method and policy structure. Understanding the “cost basis” is fundamental to determining tax liability. The cost basis refers to the total premiums paid into the policy.

Policy loans are typically not taxable income as long as the policy remains in force. However, if a policy lapses or is surrendered with an outstanding loan, the loan amount, to the extent it represents a gain, can become taxable income. This is because the loan is no longer collateralized by an active policy and is treated as a distribution of untaxed gains.

Partial withdrawals are generally taxed on a “first-in, first-out” (FIFO) basis. Withdrawals are first considered a tax-free return of the premiums paid (cost basis). Once total withdrawals exceed the policy’s cost basis, any additional amounts are taxable gains subject to ordinary income tax.

When a policy is surrendered, any amount received exceeding the policy’s cost basis is subject to ordinary income tax. For instance, if the total premiums paid were $50,000 and the cash surrender value is $65,000, the $15,000 gain would be taxable. This gain is taxed at the policyholder’s ordinary income tax rate.

A Modified Endowment Contract (MEC) is a life insurance policy funded too quickly, failing the “7-pay test.” The 7-pay test determines if cumulative premiums paid within the first seven years exceed the amount necessary to pay up the policy in seven equal annual payments. If a policy becomes a MEC, its tax treatment changes significantly. Loans and withdrawals from a MEC are taxed on a “last-in, first-out” (LIFO) basis, meaning gains are taxed first. Distributions from a MEC before age 59½ may also be subject to a 10% federal penalty tax, similar to early distributions from retirement accounts.