What Happens If I Cancel My Life Insurance?

Life insurance provides a lump sum payment, known as a death benefit, to designated beneficiaries upon the death of the insured individual. Policyholders pay regular premiums to maintain this coverage, ensuring a financial safety net for their loved ones. Cancelling a life insurance policy is a significant financial decision with direct consequences.

Cessation of Coverage

The primary consequence of cancelling any life insurance policy is the immediate termination of its death benefit. Once a policy is cancelled, the insurance company is no longer obligated to pay out the death benefit to the designated beneficiaries. This directly impacts the financial security the policy was intended to provide.

Beneficiaries will not receive the lump sum payment that could have been used for purposes such as covering funeral expenses, settling outstanding debts, or providing ongoing living expenses. The financial protection for loved ones, the core function of life insurance, is entirely removed upon cancellation. The policy’s protective role ends the moment cancellation is finalized.

For term life insurance, cancellation means the policy ends, and coverage ceases without any residual value. Premiums paid for term policies cover the cost of insurance protection for a specific period, without building cash value. Even with permanent life insurance policies, while a cash value component may exist, the death benefit is forfeited upon cancellation, removing that layer of financial support.

Financial Consequences for Cash Value Policies

Permanent life insurance policies, such as whole life or universal life, include a cash value component. This cash value accumulates over time, growing on a tax-deferred basis, and can be accessed by the policyholder during their lifetime through policy loans or withdrawals. When a permanent life insurance policy is cancelled, the policyholder may receive a portion of this accumulated cash value, known as the cash surrender value.

The cash surrender value represents the amount remaining after the insurer deducts any applicable surrender charges or outstanding policy loans. Surrender charges are fees imposed by the insurance company when a policy is cancelled within a specified period, typically the first 5 to 15 years after its issuance. These charges are designed to help the insurer recover upfront costs associated with issuing the policy, including agent commissions and administrative expenses.

The amount of the surrender charge usually decreases over time, often on a declining schedule, until it disappears entirely after the initial surrender period. For instance, a policy might have a 10% surrender charge in the first year, which could decrease by 1% each subsequent year, reaching zero after ten years. Cancelling a policy early can result in a significantly reduced cash surrender value, or even no payout, due to these substantial surrender charges.

The specific surrender charge schedule is detailed in the policy contract. Term life insurance policies do not build cash value, as their premiums solely cover the cost of insurance protection for a defined term. Consequently, when a term life policy is cancelled, there is no cash surrender value to be received, nor are there any surrender charges applied.

Policyholders considering cancelling a permanent policy should request an in-force illustration from their insurer to determine the exact cash surrender value. This illustration will show the current cash value, any applicable surrender charges, and the net amount payable to the policyholder.

Tax Implications of Surrendering a Policy

Surrendering a cash value life insurance policy can have significant tax consequences, particularly if the cash surrender value received exceeds the policy’s cost basis. The cost basis of a life insurance policy is generally defined as the total amount of premiums paid into the policy, reduced by any dividends received in cash or previous withdrawals that were not taxable. If the cash surrender value received upon cancellation is greater than this cost basis, the difference is considered a taxable gain by the Internal Revenue Service (IRS).

This gain is typically taxed as ordinary income, not capital gains, and is subject to the policyholder’s marginal income tax rate in the year the policy is surrendered. For example, if a policyholder paid $50,000 in premiums over the years and receives a cash surrender value of $60,000, the $10,000 difference would be a taxable gain.

A special category of permanent life insurance policies, known as Modified Endowment Contracts (MECs), has distinct and less favorable tax rules upon surrender. A policy becomes an MEC if it fails the “7-pay test,” meaning the cumulative premiums paid within the first seven years exceed a specified limit set by the IRS.

For MECs, withdrawals and surrenders are subject to the “Last-In, First-Out” (LIFO) rule for tax purposes, meaning any gains are considered to be distributed first. This differs from non-MEC policies, where distributions up to the cost basis are generally tax-free. Additionally, if a policyholder surrenders an MEC and is under the age of 59½, any taxable gain is subject to an additional 10% penalty tax.

The insurance company is required to report the surrender of a life insurance policy to the IRS on Form 1099-R, “Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.”. This form details the gross distribution and the taxable amount, which the policyholder must then include on their income tax return. Given the complexities of tax law, especially concerning cost basis calculations and MEC rules, it is highly advisable for individuals considering surrendering a policy to consult with a qualified tax professional.