What Is the Cash Surrender Value of a Life Insurance Policy?

The cash surrender value of a life insurance policy is the amount a policyholder receives when they terminate their permanent life insurance policy. This value is distinct from the policy’s overall cash value and its death benefit, representing the net amount paid after fees or charges.

Understanding Cash Surrender Value

Cash surrender value is the sum a policyholder receives when they cancel, or “surrender,” a permanent life insurance policy. This amount is derived from the policy’s accumulated cash value, but it is reduced by surrender charges, outstanding loans, or unpaid fees. The cash surrender value is ultimately what the insurance company pays in a lump sum upon policy termination.

Cash surrender value is exclusive to permanent life insurance policies, such as whole life, universal life, and variable universal life insurance. Term life insurance policies, which provide coverage for a specific period without building a savings component, do not accumulate cash value and thus have no cash surrender value. The policy’s cash value is the total amount that has accumulated, but the cash surrender value is the actual payout after deductions.

How Cash Surrender Value Accumulates

Cash surrender value grows within permanent life insurance policies because a portion of each premium payment is allocated to a separate cash value account. These funds accumulate over time, creating a savings component within the policy. The cash value grows on a tax-deferred basis, meaning earnings are not taxed as they accumulate. For whole life policies, the cash value grows at a guaranteed interest rate, providing predictable accumulation. Universal life policies may have cash value growth tied to current interest rates or market-linked returns, though with a guaranteed minimum rate.

A significant factor impacting cash surrender value, especially in the early years, is the presence of surrender charges. These are fees the insurance company imposes if a policy is terminated prematurely, within the first 10 to 15 years. Surrender charges are designed to help insurers recover upfront costs and commissions. They start as a higher percentage of the cash value and gradually decrease over the surrender period, eventually phasing out completely.

Ways to Access Cash Surrender Value

Policyholders can access the financial value built within their permanent life insurance policies through several methods.

Policy Surrender

A full policy surrender occurs when the policyholder cancels the entire life insurance contract. Upon surrender, coverage terminates, and the policyholder receives the cash surrender value, which is the accumulated cash value minus surrender charges or outstanding policy loans.

Policy Loans

Policyholders can access funds through policy loans, borrowing money directly from the insurance company using the policy’s cash value as collateral. The policy remains in force, and the cash value continues to grow at a stated interest rate. Interest accrues on these loans, and any unpaid loan balance will reduce the death benefit paid to beneficiaries if the loan is not repaid before the insured’s death. These loans do not require credit checks and offer flexible repayment terms.

Partial Withdrawals

Policyholders can also make partial withdrawals from their policy’s cash value. Unlike loans, withdrawals permanently remove funds from the policy, directly reducing both the cash value and the death benefit. The policy coverage remains in effect, albeit with a reduced death benefit. Some policies allow the use of accumulated cash value to cover future premium payments, offering flexibility in maintaining coverage.

Tax Considerations for Cash Surrender Value

Accessing the cash surrender value or other cash value components of a life insurance policy involves specific tax considerations. When a policy is surrendered or withdrawals are made, amounts received up to the total premiums paid into the policy, known as the “cost basis,” are not subject to income tax. This is because the IRS views these amounts as a return of the policyholder’s own capital investment.

However, any portion of the cash surrender value that exceeds the cost basis is considered a gain and is taxable as ordinary income. This gain is taxed at the policyholder’s regular income tax rate, not at capital gains rates. Insurers may issue a Form 1099-R to report the taxable portion of a surrender.

Policy loans are not considered taxable income when taken. The IRS views them as a loan against the policy’s value rather than a distribution of earnings. However, if a policy lapses or is surrendered with an outstanding policy loan, the loan amount that exceeds the policy’s cost basis can become taxable income.

Certain life insurance policies can be classified as a Modified Endowment Contract (MEC) if they are funded too rapidly or exceed specific IRS premium limits. Once a policy becomes an MEC, its tax treatment for withdrawals and loans changes significantly. Withdrawals and loans from an MEC are taxed on a “last-in, first-out” (LIFO) basis, meaning earnings are considered to be withdrawn first and are immediately taxable as ordinary income. Additionally, withdrawals or loans from an MEC taken before age 59½ may be subject to an additional 10% early withdrawal penalty. Despite these changes, the death benefit of an MEC remains income tax-free for beneficiaries.