When Can I Cash Out My Life Insurance Policy?

Life insurance policies serve as a financial safeguard, offering a death benefit to beneficiaries upon the insured’s passing. Beyond this primary function, certain policies also accumulate a cash value, which can become a valuable financial resource during the policyholder’s lifetime. Understanding how and when to access this cash value is important for maximizing the utility of a life insurance policy. This article explains policies that build cash value, methods to access these funds, and associated financial and tax implications.

Policies with Cash Value

Life insurance policies fall into two main categories: term life and permanent life. Term life insurance provides coverage for a specific period and does not build cash value. Permanent life insurance policies provide coverage for the insured’s entire life and include a savings component that accumulates cash value over time.

Within permanent life insurance, several types exist, each with a distinct approach to cash value accumulation. Whole life insurance offers a guaranteed interest rate on its cash value, which grows predictably. A portion of each premium payment contributes to this cash value, ensuring steady growth.

Universal life insurance provides flexibility, allowing policyholders to adjust premiums and death benefits. The cash value in universal life policies earns interest based on market rates, though some may offer a guaranteed minimum. Variable universal life insurance allows policyholders to invest the cash value in various sub-accounts, similar to mutual funds. This can lead to higher growth potential but also carries investment risk, meaning cash value can fluctuate with market performance. Indexed universal life insurance links cash value growth to a specific market index, such as the S&P 500, often with caps on gains and floors on losses. The cash value in these permanent policies represents a living benefit that the policyholder can access while alive.

Accessing Your Policy’s Cash Value

Policyholders have several ways to access the cash value accumulated within their permanent life insurance policies. These methods include taking a policy loan, making a partial withdrawal, or surrendering the policy entirely. Each option has a distinct process and immediate impact on the policy’s benefits.

Taking a policy loan involves borrowing money directly from the insurer, using the policy’s cash value as collateral. Policy loans offer competitive interest rates, often ranging from 5% to 8%, and provide flexible repayment terms, with some policies not requiring mandatory repayment during the insured’s lifetime. To initiate a loan, policyholders contact their insurer and complete a form; no credit check is required. An outstanding loan balance, including accrued interest, will reduce the death benefit paid to beneficiaries if the loan is not repaid before the insured’s death.

A partial withdrawal allows the policyholder to take out a portion of the cash value directly. This option is common in universal life policies, though not available in whole life policies where loans are the primary access method. Withdrawals directly reduce the policy’s cash value and can also decrease the death benefit. The process involves submitting a request to the insurance company.

Surrendering the policy involves terminating the life insurance contract in exchange for its cash surrender value. This action provides a lump sum payment of the accumulated cash value, minus any outstanding loans or surrender charges. Surrender charges, which can be substantial in the early years of a policy, are fees imposed by the insurer for early termination. This option completely ends the insurance coverage, meaning the death benefit is forfeited, and the policyholder no longer has life insurance protection.

Understanding Financial and Tax Outcomes

Accessing a life insurance policy’s cash value carries significant financial and tax implications. The method chosen directly affects the policy’s ongoing viability and potential tax liabilities.

When a policy loan is taken, the loan itself is not considered taxable income, provided the policy remains in force. This is because a loan is treated as a debt against the policy’s value, not a distribution of earnings. However, if the policy lapses or is surrendered with an outstanding loan, the unpaid loan amount, to the extent it exceeds the policyholder’s cost basis, can become taxable as ordinary income. Unpaid interest on the loan can also accumulate, further reducing the death benefit or potentially causing the policy to lapse if the cash value can no longer support the policy charges and loan interest.

Partial withdrawals are tax-free up to the policyholder’s cost basis. The cost basis in a life insurance policy refers to the cumulative amount of premiums paid into the policy, excluding charges for riders or loan interest. Any amount withdrawn that exceeds this cost basis is taxed as ordinary income. For policies not classified as a Modified Endowment Contract (MEC), withdrawals are treated on a “first-in, first-out” (FIFO) basis, meaning the return of premiums (cost basis) is assumed to occur first, then taxable gains.

Surrendering a policy for its cash surrender value can result in a taxable event if the amount received exceeds the policy’s cost basis. The difference between the cash surrender value and the cost basis is taxed as ordinary income. For example, if $20,000 in premiums were paid and the surrender value is $30,000, the $10,000 gain would be taxable.

A policy can become a Modified Endowment Contract (MEC) if premiums paid exceed certain IRS limits within the first seven years. Once a policy is designated as a MEC, this status is irreversible. For MECs, withdrawals and loans are taxed differently: distributions are treated on a “last-in, first-out” (LIFO) basis, meaning earnings are taxed first before the return of cost basis. Distributions from a MEC taken before age 59½ are subject to a 10% early withdrawal penalty, in addition to ordinary income tax on the taxable portion.