What Is Cash Surrender Life Insurance?

Life insurance serves as a financial safeguard, offering a death benefit to beneficiaries upon the insured’s passing. While term life insurance provides coverage for a specific period, permanent life insurance policies offer lifelong protection and include an additional component known as cash value. This cash value is a savings element that can grow over time. Understanding the mechanics of this cash value, particularly its surrender value, is important for individuals considering permanent life insurance as part of their financial planning.

How Cash Value Works

Cash value is a component of permanent life insurance policies that grows over the policy’s lifetime, separate from the death benefit. A portion of each premium payment contributes to this cash value, with the remainder covering the cost of insurance and administrative fees. This accumulated cash typically grows on a tax-deferred basis, meaning earnings are not taxed until they are withdrawn or the policy is surrendered.

The growth of cash value is influenced by the type of policy. Some policies offer a guaranteed interest rate, providing predictable growth, while others tie growth to market performance or an index. Policy fees and charges, which can vary, may affect the rate at which the cash value accumulates. Over time, particularly after initial surrender charges diminish, the cash value can become a significant asset.

The cash surrender value is the amount a policyholder receives if they terminate a permanent life insurance policy. This amount is the accumulated cash value minus any applicable surrender charges, outstanding loans, or fees. Surrender charges often decrease over time, usually phasing out after 10 to 15 years, meaning the longer a policy is held, the closer the cash surrender value will be to the actual cash value.

Policies That Build Cash Value

Permanent life insurance policies are designed to offer lifelong coverage and include a cash value component. These policies differ in how their cash value accumulates and the flexibility they provide. The four main types are:

Whole Life: Known for its stability and predictability. It features a guaranteed death benefit, fixed premium payments that remain constant throughout the policy’s life, and a cash value that grows at a guaranteed interest rate. Some whole life policies may also pay dividends, which can be used to reduce premiums, increase the death benefit, or further enhance the cash value.
Universal Life (UL): Provides more flexibility compared to Whole Life policies. It allows policyholders to adjust premium payments and, in some cases, the death benefit. The cash value in a Universal Life policy grows based on an interest rate, which may be fixed or adjustable, and is influenced by the cost of insurance and administrative expenses.
Variable Universal Life (VUL): Combines the flexibility of Universal Life with an investment component. Policyholders can allocate the cash value to various investment options, such as sub-accounts that resemble mutual funds. This offers the potential for higher cash value growth tied to market performance, but it also carries investment risk, meaning the cash value can fluctuate and potentially decrease.
Indexed Universal Life (IUL): Another variation where the cash value growth is linked to a stock market index, such as the S&P 500. These policies often include a minimum guaranteed interest rate to protect against market downturns, while also capping potential gains.

Using Your Cash Value

Policyholders can access the accumulated cash value in their permanent life insurance policies through several methods during their lifetime. These options allow for financial flexibility, though they can impact the policy’s death benefit and terms. The three primary ways to utilize cash value are through withdrawals, policy loans, or surrendering the policy entirely.

Withdrawals: Making a partial withdrawal from the cash value allows a policyholder to access funds without terminating the policy. The death benefit is reduced by the amount withdrawn. Withdrawals are generally flexible, though some policies may have minimum withdrawal amounts or waiting periods before funds can be accessed.
Policy Loans: Taking a policy loan is another common way to access cash value. Policy loans use the cash value as collateral, meaning the money borrowed does not come directly from the cash value itself but from the insurer, with the policy serving as security. These loans typically do not require a credit check and often have competitive interest rates compared to traditional loans. While repayment is generally flexible and not strictly mandated by a fixed schedule, any outstanding loan balance, including accrued interest, will reduce the death benefit paid to beneficiaries if not repaid before the insured’s death.
Surrendering the Policy: This involves canceling the life insurance coverage entirely in exchange for its cash surrender value. This option provides a lump sum payment of the accumulated cash value, after any surrender charges and outstanding loans are deducted. However, surrendering the policy means the death benefit is forfeited, and the insurance coverage ceases. This decision should be carefully considered as it eliminates the financial protection for beneficiaries.

Tax Implications of Cash Value

The tax treatment of cash value life insurance is generally favorable, but specific actions can trigger tax liabilities. The growth of cash value within a permanent life insurance policy is typically tax-deferred. This means that earnings accumulate without being subject to annual income taxes, allowing the cash value to compound more efficiently.

Withdrawals: When making withdrawals from the cash value, amounts received are generally considered a return of premiums paid, up to the total amount of premiums, and are usually tax-free. If the withdrawal exceeds the total premiums paid, the excess amount, which represents earnings, may be subject to ordinary income tax. Partial withdrawals can also reduce the policy’s death benefit.
Policy Loans: Policy loans taken against the cash value are generally not considered taxable income as long as the policy remains in force. The policy’s cash value acts as collateral, and the loan is not a distribution of earnings. However, if the policy lapses or is surrendered with an outstanding loan, the loan amount that exceeds the premiums paid (cost basis) can become taxable as ordinary income. This can create an unexpected tax burden if the policy is not carefully managed.
Surrendering a Policy: Upon surrendering a policy, if the cash surrender value received exceeds the total premiums paid into the policy (the cost basis), the difference is considered a taxable gain. This gain is taxed as ordinary income, not capital gains, which can result in a higher tax rate depending on the policyholder’s income bracket. Surrender charges, which reduce the payout, do not reduce the taxable gain. If the policy is classified as a Modified Endowment Contract (MEC), withdrawals and loans may be subject to different tax rules, including potential taxation of gains first and a 10% penalty if the policyholder is under age 59½.