What Kind of Policy Allows Withdrawals?

It is beneficial to understand how various financial products can provide access to accumulated funds. Many policies or accounts allow withdrawals or loans under specific conditions. Understanding these mechanisms is an important aspect of financial planning, enabling individuals to leverage assets effectively.

Life Insurance Policies with Cash Value

Certain life insurance policies, unlike term life, build cash value over time. These include whole life, universal life, and variable universal life policies. This cash value grows on a tax-deferred basis, distinct from the policy’s death benefit.

Policyholders can access this cash value through withdrawals or policy loans. A cash value withdrawal directly reduces the policy’s cash value and the death benefit. For example, a $10,000 withdrawal from a $50,000 cash value policy reduces both by that amount.

Withdrawals are tax-free up to the amount of premiums paid, known as the cost basis. Withdrawals exceeding this cost basis are taxed as ordinary income. For instance, if $20,000 in premiums were paid and $25,000 is withdrawn from $30,000 cash value, $5,000 is taxable.

Alternatively, policyholders can take a loan against their cash value. Unlike withdrawals, policy loans do not reduce the death benefit or cash value directly, but they do accrue interest. If the loan is not repaid, the outstanding loan balance and any accrued interest will be deducted from the death benefit when the insured passes away.

If a policy becomes a Modified Endowment Contract (MEC) due to exceeding premium limits, the tax treatment of withdrawals and loans changes. For MECs, withdrawals and loans are treated as taxable income first, up to the gain, and may be subject to a 10% penalty if taken before age 59½.

Retirement Savings Accounts

Retirement savings accounts, such as 401(k)s, Traditional IRAs, and Roth IRAs, offer mechanisms for accessing funds. Withdrawals from these accounts become penalty-free once the account holder reaches age 59½. For Traditional IRAs and 401(k)s, these withdrawals are taxed as ordinary income, as contributions were made on a pre-tax basis or were tax-deductible.

Qualified withdrawals from a Roth IRA are entirely tax-free and penalty-free, provided the account has been open for at least five years and the account holder is age 59½ or meets other conditions. This tax-free benefit stems from contributions to Roth IRAs being made with after-tax dollars. Accessing funds before age 59½ incurs a 10% early withdrawal penalty on the taxable portion of the distribution, in addition to regular income taxes.

There are several common exceptions to the 10% early withdrawal penalty, though income taxes may still apply. These exceptions include:

• Distributions for unreimbursed medical expenses exceeding 7.5% of adjusted gross income.
• Qualified higher education expenses.
• A first-time home purchase, up to a $10,000 lifetime limit.
• Distributions due to total and permanent disability.
• Those taken as substantially equal periodic payments (SEPP or 72(t)).

Qualified birth or adoption distributions, up to $5,000 per individual, are also exempt from the 10% penalty. Income taxes on the withdrawn amount still apply unless it’s a qualified Roth distribution. These rules balance retirement savings goals with unexpected financial needs.

Some employer-sponsored plans, like 401(k)s, permit participants to take loans from their vested account balance. These loans must be repaid within five years, though a longer term may be allowed for a loan used to purchase a primary residence. If a 401(k) loan is not repaid, the outstanding balance can be treated as a taxable distribution and may be subject to the 10% early withdrawal penalty if the participant is under age 59½.

Annuity Contracts

Annuity contracts are agreements with an insurance company where an individual makes payments and receives regular disbursements in the future. They can be immediate, providing payments soon after purchase, or deferred, allowing funds to grow before payments begin. Deferred annuities allow for partial withdrawals from the accumulated value.

Most deferred annuity contracts permit penalty-free withdrawals of a certain percentage of the account value each year, commonly around 10%. For example, a $10,000 withdrawal from a $100,000 annuity might be allowed annually without additional charges. Withdrawals exceeding this allowance are subject to surrender charges.

Surrender charges are fees imposed by the insurance company to recoup sales commissions and expenses. These charges decline over five to ten years and are applied as a percentage of the amount withdrawn exceeding the penalty-free allowance. For example, a contract might have a 7% surrender charge in the first year, declining by 1% annually.

The tax treatment of annuity withdrawals follows a Last-In, First-Out (LIFO) rule, meaning earnings are withdrawn first and are taxable as ordinary income. After all earnings have been withdrawn and taxed, subsequent withdrawals of original principal contributions are tax-free. If withdrawals of earnings occur before the annuity holder reaches age 59½, they may be subject to an additional 10% federal income tax penalty, similar to early withdrawals from retirement accounts.

While partial withdrawals offer flexibility, another way to access annuity funds is through annuitization. Annuitization involves converting the accumulated value into a stream of regular income payments for a specified period or for life. This process differs from ad-hoc partial withdrawals as it establishes a systematic payout schedule, fundamentally altering how the funds are distributed from the contract.