When Can You Take Money Out of Life Insurance?

Life insurance policies can offer more than just a death benefit for beneficiaries; certain types also accumulate a cash value during the policyholder’s lifetime. This cash value represents a savings component within the policy, which can grow over time. This article explores the types of policies that build cash value and outlines the methods available for accessing these funds.

Life Insurance Policies with Cash Value

Life insurance policies are broadly categorized into term life and permanent life insurance. Term life insurance provides coverage for a specific period and does not accumulate cash value. Permanent life insurance policies, designed to provide coverage for an individual’s entire life, include a cash value component that grows over time.

Cash value is a portion of the premium payments allocated to a savings or investment component within a permanent life insurance policy. This value can be used by the policyholder during their lifetime. The cash value grows on a tax-deferred basis, meaning earnings are not taxed until they are withdrawn.

Several types of permanent life insurance build cash value, each with distinct characteristics regarding how this value accumulates. Whole life insurance policies offer guaranteed cash value growth at a fixed interest rate, and this growth is predictable over the life of the policy. Universal life insurance policies provide more flexibility, allowing adjustments to premiums and death benefits, and their cash value grows based on an interest rate that may vary but has a guaranteed minimum.

Variable universal life insurance policies link the cash value growth to investment options, such as stocks and bonds, chosen by the policyholder. This offers the potential for higher returns but involves greater risk due to market fluctuations. Indexed universal life insurance policies tie cash value growth to a market index, like the S&P 500, with a floor to protect against losses and a cap on gains.

Methods to Access Your Cash Value

Policyholders have several options to access the accumulated cash value within their permanent life insurance policies. These methods allow access to funds during the insured’s lifetime, but each carries implications for the policy and its death benefit.

One method is taking a policy loan, where the policyholder borrows money from the insurer, using the cash value as collateral. The policy remains in force, and the loan is interest-bearing, with rates that can vary. If the loan and accrued interest are not repaid, the death benefit payable to beneficiaries will be reduced by the outstanding amount.

Another way to access funds is through partial withdrawals from the cash value. This method directly reduces the cash value and, in most cases, also decreases the policy’s death benefit. Unlike a loan, a withdrawal is a permanent reduction of the cash value and does not need to be repaid. The policy remains in force after a partial withdrawal, provided sufficient cash value remains to cover ongoing policy charges.

The third method is a full surrender of the policy. This involves terminating the life insurance policy entirely, at which point the insurer pays out the cash surrender value to the policyholder. The cash surrender value is the accumulated cash value minus any outstanding loans, unpaid premiums, and surrender charges, which are fees for early termination. Surrendering the policy ends all coverage, and the death benefit is no longer available to beneficiaries.

Taxation of Cash Value Access

Accessing funds from a life insurance policy’s cash value carries tax implications that policyholders should consider. The tax treatment differs depending on the method of access and the policy’s classification.

Policy loans are not considered taxable income because they are treated as a debt against the policy’s cash value. However, if the policy lapses or is surrendered with an outstanding loan, the unpaid loan amount, up to the policy’s gain, can become taxable as ordinary income. The interest accrued on the loan is not tax-deductible.

Partial withdrawals from a life insurance policy are taxed under the “First-In, First-Out” (FIFO) rule. The portion of the withdrawal representing the return of premiums paid into the policy (your cost basis) is received tax-free. Only the amount withdrawn that exceeds the total premiums paid is considered taxable income, as it represents the policy’s earnings.

When a policy is fully surrendered, any amount received that exceeds the total premiums paid into the policy (your cost basis) is considered taxable income. This gain is taxed at ordinary income rates, not capital gains rates, which can lead to a higher tax liability depending on the policyholder’s income bracket. Surrender charges, if applicable, reduce the cash surrender value received but do not reduce the taxable gain.

A significant tax consideration arises if a policy is classified as a Modified Endowment Contract (MEC). A policy becomes an MEC if the premiums paid exceed certain IRS limits within the first seven years, as determined by the 7-Pay Test. Once designated an MEC, this classification is permanent and cannot be reversed.

For MECs, the tax rules for withdrawals and loans are less favorable, operating under a “Last-In, First-Out” (LIFO) basis. Any distributions, including loans, are presumed to come from policy earnings first, making them immediately taxable as ordinary income to the extent of any gain. Distributions from an MEC before the policyholder reaches age 59½ are subject to an additional 10% federal penalty tax on the taxable portion, similar to early withdrawals from retirement accounts. Consulting with a tax professional is advisable before accessing cash value.

Effects on Your Policy and Beneficiaries

Accessing the cash value of a life insurance policy has consequences that extend beyond taxation, impacting the policy’s design and its future benefits. These actions can alter the policy’s original purpose and affect the financial security intended for beneficiaries.

One effect is the reduction of the death benefit payable to beneficiaries. Both policy loans and partial withdrawals directly decrease the amount that will be paid out upon the insured’s death if they are not repaid or if the cash value is permanently reduced. This can diminish the financial protection intended for loved ones.

Significant loans or withdrawals can increase the risk of the policy lapsing. If the outstanding loan balance, including accrued interest, grows to exceed the policy’s cash value, or if withdrawals deplete the cash value below the level needed to cover ongoing policy charges, the policy could terminate. A lapse means the loss of coverage and, if an outstanding loan exists, could trigger a taxable event on the loan amount.

The performance and stability of the policy is affected. For policies designed to become self-sustaining, where cash value growth can cover premiums, accessing funds can disrupt this progression. It may require continued out-of-pocket premium payments or higher future premiums to maintain the desired death benefit.

Accessing cash value alters the policy’s role in a broader financial strategy. What might have been intended for long-term goals, such as retirement income supplementation or estate planning, could be compromised by immediate liquidity needs. This can undermine the policyholder’s intent to provide financial support or legacy for their heirs.