What Life Insurance Can You Cash Out?

Life insurance provides a financial safety net, offering a death benefit to beneficiaries upon the insured’s passing. Some policies also include a savings component called cash value. This feature allows a portion of premiums to accumulate, offering a living benefit accessible during the policyholder’s lifetime. Understanding the distinction between policies providing only a death benefit and those building cash value is important for individuals considering their financial planning options.

Understanding Cash Value Life Insurance

Cash value in life insurance represents a savings element within certain permanent life insurance policies, distinct from the death benefit paid to beneficiaries. A portion of each premium contributes to the cash value, while other parts cover insurance costs and administrative expenses. This cash value grows on a tax-deferred basis.

Whole life insurance is a permanent policy with a guaranteed cash value that grows at a fixed rate set by the insurer. Premiums for whole life policies are fixed and remain level. Universal life insurance offers more flexibility, allowing policyholders to adjust premiums and death benefits within limits. Its cash value generally grows based on an interest rate that may adjust periodically, often with a guaranteed minimum rate.

Indexed universal life (IUL) insurance ties its cash value growth to a market index, such as the S&P 500, but does not directly invest in the market. These policies include a minimum guaranteed interest rate to protect against market downturns, and annual gains may be capped. Variable universal life (VUL) insurance allows the cash value to be invested in various sub-accounts, similar to mutual funds, chosen by the policyholder. This offers potential for higher returns but carries market risk, meaning the cash value can fluctuate with investment performance. Unlike these permanent policies, term life insurance provides coverage for a specific period and does not build cash value.

Accessing Your Policy’s Cash Value

Policyholders can access the cash value within their permanent life insurance policies in several ways. One method is taking a policy loan. Policy loans allow borrowing money from the insurer, using the cash value as collateral. Interest is charged on these loans, and any unpaid loan balance, including accrued interest, will reduce the death benefit. These are loans from the insurer, not withdrawals, and the policy generally remains in force.

Another way to access funds is through withdrawals. Policyholders can withdraw a portion of their cash value. Withdrawals reduce the policy’s cash value and the death benefit. Significant withdrawals can lead to the policy lapsing if there is insufficient cash value to cover ongoing charges.

Surrendering the policy involves terminating coverage entirely to receive the cash surrender value. This value is the accumulated cash value minus any applicable surrender charges. Surrendering the policy ends coverage, meaning no death benefit will be paid to beneficiaries. Cash value can also be used to pay policy premiums, which can reduce out-of-pocket expenses while maintaining coverage. In some cases, cash value can serve as collateral for external loans from banks or other lending institutions.

Consequences of Accessing Cash Value

Accessing a life insurance policy’s cash value can have various financial and policy implications. A primary consequence is the impact on the death benefit. Loans and withdrawals directly reduce the death benefit if not repaid. If a policy is surrendered, the death benefit is eliminated entirely as coverage ceases.

Tax implications are a significant consideration. Policy loans are not considered taxable income as long as the policy remains in force. However, if the policy lapses or is surrendered with an outstanding loan, the loan amount exceeding premiums paid can become taxable income. Withdrawals are tax-free up to the amount of premiums paid into the policy (known as the cost basis). Any amount withdrawn exceeding this cost basis is taxed as ordinary income. When a policy is surrendered, any gain (cash surrender value exceeding total premiums paid) is subject to taxation as ordinary income.

A policy can be classified as a Modified Endowment Contract (MEC) if it receives premiums exceeding certain IRS limits within its first seven years. Once an MEC, withdrawals and loans are subject to different tax rules. They are taxed on a “last-in, first-out” (LIFO) basis, meaning earnings are considered withdrawn first and are taxable as ordinary income. Withdrawals or loans from an MEC before age 59½ may incur a 10% federal tax penalty, similar to distributions from qualified retirement plans.

Accessing cash value, particularly through withdrawals or unmanaged loans, can increase the risk of policy lapse. If the cash value is depleted and can no longer cover ongoing charges and fees, the policy may terminate, leading to a loss of coverage. Many permanent life insurance policies include surrender charges, especially during early years. These charges reduce the amount received when a policy is surrendered. Surrender charges typically decrease over time and may disappear after a period, often 10 to 15 years.