What Is a Cash Surrender of a Life Insurance Policy?

A life insurance policy’s cash surrender refers to the process of terminating a policy that has accumulated a cash value and receiving a payout from the insurance company. This action effectively ends the insurance coverage, and the policyholder receives the available cash value, minus any applicable fees or outstanding loans.

Understanding Cash Value in Life Insurance

Cash value represents an accumulated savings component within certain types of permanent life insurance policies. This distinct feature allows a portion of the premiums paid to grow over time, separate from the death benefit. Unlike term life insurance, which provides coverage for a specific period without building cash value, permanent policies are designed to last for the insured’s entire life.

Policies such as whole life, universal life, and variable universal life typically build cash value. Whole life policies offer a guaranteed cash value growth rate and fixed premiums, providing predictable accumulation. Universal life policies offer more flexibility in premium payments and death benefits, with cash value growth tied to an interest rate set by the insurer. Variable universal life policies allow the policyholder to invest the cash value in various sub-accounts, offering potential for higher growth but also greater risk.

Cash value accumulates over time as a portion of each premium payment is allocated to this component, rather than solely to the cost of insurance. This allocated amount then grows on a tax-deferred basis, typically earning interest or investment returns.

Methods for Accessing Policy Cash Value

Fully surrendering a life insurance policy for its cash value involves a specific process initiated by the policyholder. To begin, the policyholder typically contacts their insurance company to express their intent to surrender the policy. The insurer will then provide the necessary forms, which usually require the policyholder’s signature, policy number, and sometimes identification verification. Once the completed forms are submitted and processed, the insurance company will calculate the final surrender value, deduct any outstanding policy loans or fees, and issue a check or direct deposit. Policyholders also have alternative methods to access their cash value without fully terminating the policy:

Policy loans: Policyholders can borrow money directly from the insurer, using the cash value as collateral. These loans typically accrue interest, and if not repaid, the outstanding balance and interest will reduce the death benefit or cash value. Unlike traditional loans, policy loans generally do not require credit checks and do not have a fixed repayment schedule, though unpaid interest can compound.
Partial withdrawals: A portion of the cash value is directly withdrawn from the policy. Withdrawals reduce the policy’s cash value and death benefit, and if the amount withdrawn exceeds the premiums paid into the policy, the excess may be subject to taxation.
Reduced paid-up option: This uses the existing cash value to purchase a smaller, fully paid-up policy, meaning no further premiums are required.
Extended term option: This allows the policyholder to use the cash value to purchase a term policy for the original face amount for a specified period. This option maintains the death benefit for a limited time without further premium payments.
1035 exchange: This allows policyholders to transfer the cash value from an existing life insurance policy to another qualifying life insurance policy or annuity without triggering a taxable event. This exchange can be beneficial for those looking to switch insurers or policy types while maintaining the tax-deferred growth of their cash value.

Tax and Financial Considerations of Cash Surrender

When a life insurance policy is surrendered, financial implications arise, particularly concerning surrender charges. These charges are fees imposed by the insurance company, typically during the early years of a policy, to recoup expenses associated with policy issuance and commissions. The surrender charge period can vary, often lasting for 10 to 20 years from the policy’s inception, and the amount of the charge typically declines over time. The actual payout received by the policyholder is the cash value minus any applicable surrender charges and outstanding policy loans.

The “basis” in a life insurance policy generally refers to the total premiums paid into the policy, less any prior tax-free withdrawals or dividends received. When a policy is surrendered, the amount received up to the policy’s basis is typically returned tax-free. However, any amount received that exceeds this basis is considered a taxable gain and is taxed as ordinary income.

For example, if a policyholder paid $50,000 in premiums and received $65,000 upon surrender, the $15,000 difference would be subject to ordinary income tax rates. The insurance company is generally required to report the taxable gain to the Internal Revenue Service (IRS) and the policyholder by issuing IRS Form 1099-R. This form details the gross distribution and the taxable amount.