What Happens If I Cancel My Life Insurance Policy?

Canceling a life insurance policy is a significant financial decision. Understanding its implications for your coverage, financial standing, and future insurability is important for informed planning.

Impact on Coverage

Canceling a life insurance policy immediately ends its coverage. The death benefit is no longer active, and beneficiaries will not receive a payout upon the insured’s death.

Canceling a policy can affect future insurability. Should you need new coverage, premiums may be higher due to increased age or health changes since the original policy was issued. New policies also often have waiting periods for benefits, which would restart.

Financial Considerations

For permanent life insurance policies, such as whole or universal life, cancellation involves the cash surrender value. This is the amount a policyholder receives when terminating a policy before maturity, calculated as the accumulated cash value minus any surrender charges or outstanding policy loans.

Surrender charges are fees imposed by the insurer for premature cancellation. These charges are highest in early years and typically decrease over time, sometimes phasing out after 10 to 15 years. For example, fees might start around 10% of the cash value in the first year and gradually reduce. The net cash surrender value is the amount received after these charges are deducted.

The tax implications of receiving cash surrender value are important. If the cash surrender value exceeds total premiums paid, the difference is generally considered a taxable gain by the IRS. This gain is typically taxed as ordinary income. For example, if you paid $20,000 in premiums and receive a $30,000 cash surrender value, the $10,000 gain is subject to ordinary income tax.

IRS Section 72 governs the tax treatment of distributions from life insurance contracts. Any amount received that exceeds the investment in the contract (premiums paid) is included in gross income. If a gain is realized, the insurance company may issue a Form 1099-R. Consult a tax professional for specific tax consequences.

Exploring Other Options

Before proceeding with an outright cancellation, especially for permanent life insurance policies that have accumulated cash value, several alternatives exist that might better suit your needs. These options allow you to access the policy’s value or adjust coverage without completely forfeiting your investment.

One alternative is the reduced paid-up option, which uses the existing cash value to purchase a smaller, fully paid-up whole life policy. This means you stop paying premiums, but a reduced death benefit remains in force for the rest of your life. The amount of this new, smaller death benefit is determined by the cash value available at the time of conversion.

Another option is the extended term option, where the policy’s cash value is used to purchase a term life insurance policy for the original death benefit amount for a limited period. This allows you to maintain the full death benefit for a specified duration without further premium payments. The length of this extended term depends on the available cash value and your age.

Policy loans offer a way to access cash value without canceling the policy. You can borrow against the cash value, typically up to 90% of its amount, and the policy itself serves as collateral. These loans usually do not require a credit check or a formal application process. While repayment is often flexible and not strictly required on a set schedule, any outstanding loan balance and accrued interest will reduce the death benefit paid to beneficiaries if the loan is not repaid before your passing.

For universal life policies, partial withdrawals are also possible. This allows you to withdraw a portion of the available cash value while keeping some or all of the coverage in force. Unlike loans, amounts withdrawn are generally not repayable and permanently reduce the policy’s cash value and often the death benefit. Partial withdrawals may also have tax implications if the amount withdrawn exceeds the premiums paid.

Steps to Cancel

If you determine that canceling your life insurance policy is the appropriate decision, following a clear procedure helps ensure the process is completed smoothly. The first step involves contacting your insurance company directly. You can typically do this by phone, email, or through your insurance agent.

During this initial contact, you will need to inform them of your intent to cancel the policy and request any specific cancellation forms. The insurer will likely provide details on the required documentation and the effective date of the cancellation. You may need to complete and submit these forms, and some companies might also require the return of the original policy document.

It is important to confirm with the insurance company whether there are any outstanding premiums, loans, or fees that need to be settled prior to the cancellation. Once all necessary paperwork is submitted and any financial obligations are addressed, the company will process your request. Finally, you should receive a formal confirmation of the policy’s cancellation and, if applicable, details regarding the disbursement of any cash surrender value.