When Can You Cash Out Life Insurance?

Life insurance policies offer financial protection for beneficiaries after an insured’s passing. Certain types also accumulate a cash value, representing a portion of premiums paid that grows over time. This cash value can become a financial resource accessible to the policyholder during their lifetime. Understanding how and when these funds can be accessed is important for policyholders.

Life Insurance Policies with Cash Value

Not all life insurance policies build cash value; term life insurance, for instance, provides coverage for a specific period and does not accumulate cash value. Permanent life insurance policies, such as whole life, universal life, and variable universal life, remain in force for life and include a savings component that accumulates cash value. This cash value grows on a tax-deferred basis over the policy’s lifetime.

Whole life insurance policies accrue cash value at a guaranteed rate. Universal life insurance policies offer more flexibility, allowing the cash value to grow based on interest credited to the account, which can fluctuate. Variable universal life policies link the cash value growth to the performance of underlying investment sub-accounts chosen by the policyholder, introducing both higher potential returns and greater risk.

Ways to Access Your Policy’s Cash Value

Policyholders have several methods to access their policy’s cash value. Each method has distinct mechanics and implications for the policy’s future. The main methods include taking a policy loan, making a cash withdrawal, or completely surrendering the policy.

A policy loan allows the policyholder to borrow money using the policy’s cash value as collateral. The policy remains in force, and interest accrues on the outstanding loan balance at a rate set by the insurer. While repayment of the loan is generally optional, any outstanding loan balance will reduce the death benefit paid to beneficiaries.

Cash withdrawals remove funds from the policy’s cash value. Unlike a loan, a withdrawal permanently reduces the policy’s cash value and its death benefit. Significant withdrawals can also diminish the cash value to a point where it can no longer sustain the policy’s expenses, potentially leading to the policy lapsing if additional premiums are not paid.

Surrendering the policy involves terminating the life insurance contract in exchange for its net cash surrender value. This action ends all coverage, including the death benefit, and the policyholder receives the cash value minus any surrender charges or outstanding loans. Surrender charges are higher in early years and decrease over time. This option is chosen when the policyholder no longer needs the coverage or requires a large sum of money.

Tax Considerations for Cash Value Access

Accessing a life insurance policy’s cash value can have tax implications. Understanding these tax rules is important for policyholders to avoid unexpected tax liabilities. The Internal Revenue Service (IRS) treats policy loans differently from withdrawals and surrenders.

Policy loans are considered tax-free distributions as long as the policy remains in force. This is because the loan is viewed as borrowing against your own asset, not as income. However, if the policy lapses or is surrendered with an outstanding loan, the loan amount exceeding the policy’s cost basis (total premiums paid less dividends received) can become taxable income. This occurs because the loan is no longer collateralized by an active policy, and the funds are treated as a distribution.

Cash withdrawals are tax-free up to the policy’s cost basis. The cost basis represents the cumulative premiums paid into the policy, reduced by any dividends or prior tax-free distributions received. Any portion of a withdrawal that exceeds this cost basis is considered taxable income and is taxed at ordinary income rates. This “first-in, first-out” (FIFO) rule means that the IRS assumes you are withdrawing your principal (premiums paid) first before any accumulated earnings.

Surrendering a policy results in taxable income if the cash surrender value received exceeds the policyholder’s cost basis. This difference, representing the accumulated earnings within the policy, is taxed as ordinary income. For example, if a policyholder paid $50,000 in premiums and receives $60,000 upon surrender, the $10,000 gain would be subject to income tax. Insurers will issue a Form 1099-R reporting any taxable distributions from a surrendered policy.

Consequences for Your Policy and Beneficiaries

Accessing a life insurance policy’s cash value has consequences affecting the policy’s longevity and its intended beneficiaries. These impacts can alter the original purpose and benefits of the life insurance coverage. Policyholders should consider these outcomes before making any decisions.

Accessing cash value reduces the policy’s death benefit. Any outstanding loan balance will be subtracted from the death benefit paid to beneficiaries. Cash withdrawals decrease the policy’s face amount. This reduction impacts the financial security for beneficiaries.

Withdrawals or unpaid policy loans can also increase the risk of the policy lapsing. If the cash value is depleted, the policy may terminate if additional premiums are not paid. This situation leaves the policyholder without coverage and the beneficiaries without a death benefit. The policy’s ability to cover future premiums can be hampered.

Accessing cash value can also diminish the policy’s overall financial performance. For participating whole life policies, reducing the cash value can impact future dividend payments, as dividends are tied to the policy’s financial strength. The primary purpose of life insurance, to provide a financial safety net for dependents, is diminished when the policy’s value is drawn upon. This affects the financial provision planned for beneficiaries.