What Types of Life Insurance Can You Cash Out?

Life insurance policies offer more than just a death benefit for beneficiaries. Certain types of policies develop a “cash value,” a living benefit policyholders can access during their lifetime. This cash component grows separately from the death benefit, providing a financial resource. Understanding how this cash value accumulates and can be accessed is important.

Types of Cash Value Life Insurance

Several categories of life insurance policies build cash value, each with distinct features.
Whole life insurance is a traditional option, characterized by guaranteed cash value growth, fixed premiums, and a constant death benefit. Some whole life policies may also pay dividends, enhancing cash value or reducing premiums.

Universal life insurance offers more flexibility, allowing policyholders to adjust premium payments and death benefit amounts. Its cash value grows based on a declared interest rate, which can fluctuate but often has a guaranteed minimum.

Variable universal life insurance introduces an investment component, linking cash value growth to the performance of underlying investment sub-accounts chosen by the policyholder. These sub-accounts carry investment risk, meaning cash value can increase or decrease based on market performance. This policy offers potential for higher returns but also greater risk.

Indexed universal life insurance links its cash value growth to a specific market index, such as the S&P 500. While tied to an index, these policies often include a “floor” to protect against market downturns and a “cap” that limits the maximum interest rate credited.

Understanding Cash Value Accumulation

Cash value accrues within a permanent life insurance policy through a specific allocation of premium payments. A portion of each premium covers the cost of insurance, administrative expenses, and fees. The remaining portion is directed into the policy’s cash value component.

Cash value grows in different ways, depending on the policy type. Whole life policies offer guaranteed growth at a predetermined rate. Universal life policies credit interest based on a declared rate, which can vary but includes a minimum guarantee.

For variable universal life policies, cash value growth ties directly to the performance of chosen investment sub-accounts. Indexed universal life policies link their cash value growth to a market index, crediting interest based on its performance, subject to caps and floors. The growth of the cash value is generally tax-deferred, meaning taxes are not paid on gains until the money is accessed.

Methods for Accessing Cash Value

Policyholders have several ways to access the cash value within their permanent life insurance policies.
One common method is taking a policy loan, where the policyholder borrows money directly from the insurer, using the cash value as collateral. The loan amount reduces the policy’s death benefit by the outstanding loan balance if not repaid before the policyholder’s death.

Policy loans accrue interest, which the policyholder is expected to repay. While there is no strict repayment schedule, failure to repay interest or principal can lead to the loan balance exceeding the cash value, potentially causing the policy to lapse. If the policy lapses with an outstanding loan, the loan amount may become taxable up to the policy’s gain.

Another method is a withdrawal, also known as a partial surrender, where the policyholder takes a portion of the cash value directly from the policy. Unlike a loan, a withdrawal permanently reduces the cash value and can also reduce the policy’s death benefit. The amount withdrawn is no longer part of the policy and does not need repayment.

Finally, a policyholder can surrender the policy entirely for its net cash surrender value. This action terminates the life insurance coverage and the death benefit. The net cash surrender value is the accumulated cash value minus any outstanding loans, surrender charges, or other fees.

Tax Treatment of Cash Value Access

The tax implications of accessing cash value vary by method. Policy loans are considered tax-free distributions, treated as a debt against the policy. However, if a policy lapses or is surrendered with an outstanding loan, the loan amount (up to the policy’s gain) can become taxable income. This occurs because the loan is no longer a debt but a distribution of previously untaxed gains.

Withdrawals from a life insurance policy are tax-free up to the amount of premiums paid into the policy, known as the policyholder’s “cost basis.” Any amount withdrawn exceeding this cost basis is considered taxable income and taxed at ordinary income rates. This “first-in, first-out” (FIFO) rule means the policyholder withdraws their own contributions first.

When a policy is fully surrendered, any amount received exceeding the policyholder’s cost basis is taxable as ordinary income. For example, if a policyholder paid $50,000 in premiums and surrenders the policy for $60,000, the $10,000 difference is considered taxable gain. This gain is reported to the IRS on Form 1099-R.

Modified Endowment Contracts (MECs) are life insurance policies that have exceeded certain IRS premium funding limits, as defined by Section 7702A. Once a policy becomes an MEC, its tax treatment for withdrawals and loans changes. Distributions from MECs, including loans and withdrawals, are subject to “last-in, first-out” (LIFO) taxation, meaning earnings are distributed first and are taxable. Additionally, distributions from an MEC before age 59½ may be subject to a 10% federal income tax penalty on the taxable portion, similar to early withdrawals from retirement accounts.