What Happens When You Take Cash Value From Life Insurance?

Life insurance policies with a cash value component, such as whole life or universal life, offer more than just a death benefit for beneficiaries. These policies build a cash value over time, providing a savings element that policyholders can access during their lifetime. This article explores the methods to access this cash value and their implications.

Ways to Access Cash Value

Policyholders have several primary methods for accessing the cash value accumulated within their permanent life insurance policies. Each method offers a different approach to utilizing the policy’s living benefits.

One common method is a cash value withdrawal, where a portion of the accumulated funds is directly taken out of the policy. Another option involves taking a policy loan, which means borrowing money from the insurer and using the policy’s cash value as collateral. The third primary method is a policy surrender, which entails terminating the insurance coverage entirely to receive the available cash value.

What Happens with a Cash Value Withdrawal

When a policyholder chooses to make a cash value withdrawal, the action directly reduces the policy’s death benefit by the amount withdrawn. For instance, a $10,000 withdrawal from a policy with a $100,000 death benefit would leave a reduced death benefit of $90,000 for beneficiaries. This reduction is permanent, as withdrawals do not need to be repaid.

The tax treatment of cash value withdrawals is important. Withdrawals are generally treated as a return of premiums paid into the policy, which is considered the policy’s cost basis. Amounts withdrawn up to this cost basis are received tax-free. However, any amount withdrawn in excess of the premiums paid is considered a gain and is taxable as ordinary income. For example, if $20,000 in premiums were paid and $25,000 is withdrawn, the initial $20,000 is tax-free, but the remaining $5,000 is subject to ordinary income tax.

The decision to withdraw funds can also impact the policy’s future growth potential. With a reduced cash value, the base upon which future interest or dividends accumulate is smaller. This can lead to slower cash value growth over time. Some policies may impose penalties or charges for withdrawals, especially if they occur early or exceed certain limits. Excessive withdrawals can lead to policy termination.

What Happens with a Policy Loan

Taking a policy loan allows a policyholder to borrow money from the insurance company, using the policy’s cash value as collateral. An advantage of this method is that the cash value continues to accrue interest or earn dividends, even while a loan is outstanding. Policy loans do not require credit checks and offer flexible repayment terms, without a fixed repayment schedule.

Interest is charged on the loan, and this rate can vary, often ranging from 4% to 7.5%. If the interest on the loan is not paid, it can be added to the loan principal, leading to a compounding effect where the loan balance grows more rapidly. An outstanding loan balance, including accrued interest, directly reduces the death benefit paid to beneficiaries. For example, a $20,000 loan with $1,000 in accrued interest would reduce a $100,000 death benefit to $79,000.

A risk with policy loans is the potential for policy lapse. If the outstanding loan balance, combined with accrued interest, grows to exceed the policy’s cash value, the policy can terminate. This situation can trigger adverse tax consequences, as the portion of the loan amount that exceeds the policy’s cost basis can become taxable as ordinary income. For instance, if a policy lapses with an outstanding loan, the policyholder might receive a Form 1099-R for the taxable gain, even if no cash was received. While repayment is flexible, failing to manage the loan can lead to policy termination and a potential tax bill.

What Happens with a Policy Surrender

Surrendering a life insurance policy is a definitive action that terminates all coverage. When a policy is surrendered, the death benefit is eliminated, and the policyholder is no longer obligated to pay future premiums.

Upon surrender, the policyholder receives the cash surrender value, which is the accumulated cash value minus any applicable charges. Surrender charges are fees deducted by the insurance company, common in the early years of a policy, often within the first 10 to 15 years. These charges can be substantial, sometimes starting at 10% or more of the cash value in the first year and gradually decreasing over time. The actual amount received can be significantly less than the accumulated cash value, especially if the policy is surrendered early.

The tax implications of a policy surrender are important. Any amount received from the surrender that exceeds the policy’s cost basis (the total premiums paid) is considered a taxable gain. This gain is taxed as ordinary income, not as capital gains. For example, if a policyholder paid $30,000 in premiums and receives a cash surrender value of $45,000, the $15,000 gain would be taxable. Once a policy is surrendered, it cannot be reinstated, making it a final decision with lasting financial and coverage implications.