What Is a Cash Surrender Value on a Life Insurance Policy?

Cash surrender value refers to the amount of money a policyholder receives when they terminate a permanent life insurance policy. This value represents the accumulated savings component of the policy, minus any applicable fees or outstanding obligations.

Understanding Cash Surrender Value

Cash surrender value is available with permanent life insurance policies like whole life, universal life, and variable universal life insurance. Unlike term life insurance, which doesn’t build cash value, permanent policies include a savings or investment component that grows over time. This cash value is separate from the death benefit and represents an equity stake.

It differs from the total cash value. It is the cash value reduced by any surrender charges, outstanding policy loans, or prior withdrawals. When a policy is surrendered, the policyholder receives this net amount, and the insurance coverage ceases. Beneficiaries will no longer receive a death benefit.

Factors Influencing Cash Surrender Value Growth

A portion of each premium payment contributes to the cash value, while other portions cover insurance costs and administrative expenses. This amount accumulates, forming the basis of the cash value. Its growth rate depends on the policy type.

Whole life policies offer a guaranteed interest rate for steady growth and may also pay dividends. Universal life policies’ cash value grows based on fluctuating interest rates, often with a guaranteed minimum. Variable universal life policies invest the cash value in sub-accounts, linking growth to investment performance, introducing potential for higher returns and risk of loss.

While premiums and earnings contribute to growth, various charges and fees, including mortality charges, administrative fees, and rider charges, can reduce the cash surrender value. A significant deduction is the surrender charge, a fee levied if the policy is terminated within a specified period (often 10-20 years). These charges discourage early cancellation and decrease over time, eventually phasing out.

Options for Using Cash Surrender Value

Policyholders can access their cash surrender value without terminating the policy. One option is a policy loan, where the policyholder borrows against it. The cash value serves as collateral, and interest rates are often competitive (5-8%). While there’s no strict repayment schedule, any outstanding loan balance, including accrued interest, reduces the death benefit if not repaid. If the loan balance exceeds the cash value, the policy can lapse, leading to loss of coverage.

Another option is partial withdrawals from the cash value. Withdrawing a portion directly reduces both the policy’s cash value and death benefit. These withdrawals are tax-free up to the premiums paid, known as the cost basis. However, withdrawing amounts exceeding the cost basis or taking too much cash can lead to policy lapse.

Finally, a policyholder can fully surrender the policy. This terminates coverage, and the policyholder receives the cash surrender value (accumulated cash value minus outstanding loans, prior withdrawals, and surrender charges). While this provides a lump-sum, beneficiaries will no longer receive a death benefit, and the individual loses life insurance protection.

Tax Implications of Cash Surrender Value

The cash value component of a permanent life insurance policy grows on a tax-deferred basis, meaning earnings are not taxed as they accumulate. However, tax implications arise when the money is accessed. The “cost basis” refers to the total premiums paid into the policy.

Policy loans are not considered taxable income, as a debt against the policy’s collateral. However, if the policy lapses or is surrendered with an outstanding loan, the loan amount exceeding the cost basis can become taxable. This can result in a significant tax bill if substantial gains accumulated.

Partial withdrawals are tax-free up to the policy’s cost basis. Amounts exceeding this cost basis are considered taxable income. This taxation follows a “first-in, first-out” (FIFO) rule for non-Modified Endowment Contracts (MECs), meaning the cost basis is assumed to be withdrawn first.

When a policy is fully surrendered, any amount received exceeding the policy’s cost basis is considered taxable income. This gain is taxed as ordinary income, not capital gains. A policy may be classified as a Modified Endowment Contract (MEC) if premiums exceed certain IRS limits within the first seven years. MECs have different tax rules: withdrawals and loans are taxed on a “last-in, first-out” (LIFO) basis, meaning gains are considered withdrawn first and are immediately taxable, often with a 10% penalty if the policyholder is under age 59½. Consult a tax professional for advice on these complex rules.