In tough economic times, people are sometimes left scrambling for cash to meet everyday expenses and lifestyle demands. Sure, you can cash in your life insurance policy to access needed funds—but should you?
There are certainly drawbacks to using life insurance to meet immediate cash needs, significantly if you're compromising your long-term goals or your family's financial future. Nevertheless, if other options are not available, life insurance—especially cash-value life insurance—can be a source of needed income.
- If you are out of options and must access your life insurance policy, it's better to withdraw or borrow cash, instead of surrendering the policy altogether.
- Cash-value life insurance policies such as whole life or universal life include a cash accumulation account within the policy, where excess premium payments and earnings are held.
- Such accounts allow policyholders to access that money through withdrawals, policy loans, or—if they need to—through surrendering the account, either in part or in full.
- You only need to pay taxes on amounts that exceed the total amount of premiums paid into the policy.
- Another option is to make a life settlement, meaning you sell your life insurance policy to a person or life settlement company in exchange for cash.
Cashing In Your Life Insurance
How You Can Access Cash
Cash-value life insurance offers the opportunity to access cash accumulations within the policy through withdrawals, policy loans, or partial or full surrender. Another alternative involves selling your policy for cash, a method known as a life settlement.
Remember that although cash from the policy might be helpful during stressful financial times, you could face unwanted consequences depending on the method you use to access the funds.
How to Withdrawal From a Life Insurance Policy
Generally, it is possible to withdraw limited amounts of cash from a life insurance policy. The amount available differs based on the type of policy you own and the company issuing it. The main advantage of cash-value withdrawals is they are not taxable up to your policy basis, as long as your policy is not classified as a modified endowment contract (MEC). A MEC is a term given to a life insurance policy in which the funding exceeds federal tax law limits.
However, cash-value withdrawals can have unexpected or unrealized consequences:
- Withdrawals that reduce your cash value could cause a reduction in your death benefit—a potential source of funds your beneficiaries might need for income replacement, business purposes, or wealth preservation.
- Cash-value withdrawals are not always tax-free. If, for example, you take a withdrawal during the first 15 years of the policy—and the withdrawal causes a reduction in the policy's death benefit—some or all of the withdrawn cash could be subject to taxation.
- Withdrawals are treated as taxable to the extent that they exceed your basis in the policy.
- Withdrawals that reduce your cash surrender value could cause your premiums to increase to maintain the same death benefit; otherwise, the policy could lapse.
- If your policy has been classified as a MEC, withdrawals generally are taxed according to the rules applicable to annuities—cash disbursements are considered to be made from interest first and are subject to income tax and possibly a 10% early-withdrawal penalty if you're under age 59½ at the time of the withdrawal.
Taking a Loan From Your Life Insurance
Most cash-value policies allow you to borrow money from the issuer using your cash-accumulation account as collateral. Depending on the policy terms, the loan might be subject to interest at varying rates; however, you are not obligated to qualify for the loan financially. The amount you can borrow is based on the value of the policy's cash-accumulation account and the contract's terms.
The good news is that borrowed amounts from non-MEC policies are not taxable, and you don't have to make payments on the loan, even though the outstanding loan balance might be accruing interest.
The bad news is loan balances generally reduce your policy's death benefit, meaning your beneficiaries might receive less than you intended. Also, an unpaid loan that is accruing interest reduces your cash value, which can cause the policy to lapse if insufficient premiums are paid to maintain the death benefit. If the loan is still outstanding when the policy lapses or if you later surrender the insurance, the borrowed amount becomes taxable to the extent the cash value (without reduction for the outstanding loan balance) exceeds your basis in the contract.
Policy loans from a policy that is considered a MEC are treated as distributions, meaning the loan amount up to the policy's earnings will be taxable and could also be subject to the pre-59½ early-withdrawal penalty.
Withdrawing money or borrowing money from your life insurance policy can reduce your policy's death benefit, while surrendering the policy means you are giving up the right to the death benefit altogether.
Surrendering a Policy
In addition to withdrawals and policy loans, you can surrender (cancel) your policy and use the cash any way you see fit. However, if you surrender the policy during the early years of ownership, the company will likely charge surrender fees, reducing your cash value. These charges vary depending on how long you've had the policy.
In addition, when you surrender your policy for cash, the gain on the policy is subject to income tax. Additional taxes could be incurred if you have an outstanding loan balance against the policy.
Although surrendering the policy can get you the cash you need, you're relinquishing the right to the death-benefit protection afforded by the insurance. If you want to replace the lost death benefit later, getting the same coverage might be more complicated or more expensive.
If you have the means, consider other options before using your life insurance policy for cash, such as borrowing against your 401(k) plan or taking out a home equity loan; none of these options comes without mitigating issues, but based on your current financial circumstances, some choices are better than others.
This concept is fairly simple. As the policy owner, you sell your life insurance policy to an individual or a life settlement company in exchange for cash. The new owner will keep the policy in force (by paying the premiums) and reap a return on the investment by receiving the death benefit when you die.
Most types of insurance are eligible for sale, including policies with little or no cash value, such as term insurance. Generally, to qualify for a life settlement, you (the insured) must be at least 65 years old, have a life expectancy of 10 to 15 years or less, and a policy death benefit of at least $100,000 (in most cases).
The primary advantage of a life settlement is that you can get more for the policy than by cashing it in (surrendering the policy). The taxation of life settlements is complicated: The general treatment is that gain in excess of your basis in the policy is taxed to you as ordinary income. Be sure you get expert tax advice before signing over your policy.
Although life settlements can be a valuable source of liquidity, consider the following issues:
- You're giving up control of the death benefit.
- The new policy owner(s) will have access to your past medical records and usually the right to request updates on your current health.
- The life settlement industry is very marginally regulated, so there's no guidance as to your policy's value, making it hard to determine whether you're getting a fair price for your policy.
- Aside from the tax liability that you could face, life settlements usually come with another cost: As much as 30% of your proceeds could be paid in commissions and fees, which reduces the net amount you receive.
Can You Cash Out a Life Insurance Policy?
Yes. You can cash out a life insurance policy. How much money you get for it, will depend on the amount of cash value held in it. If you have, say $10,000 of accumulated cash value, you would be entitled to withdraw up to all of that amount (less any surrender fees). At that point, however, your policy would be terminated. Instead, you can withdraw smaller amounts or take a policy loan against a portion of that value (often up to 90% of it).
Do You Have to Pay Taxes When Cashing out a Life Insurance Policy?
If you withdraw up to the amount of the total premiums paid into the policy, it is not taxable as it is considered a return of premiums. If, however, you then withdraw any gains on the policy (e.g., dividends), then these amounts could be taxed as ordinary income.
Is There a Penalty for Cashing out Life Insurance?
Some policies will have a surrender fee in the case of cashing out an entire policy. Other than that, there are no additional penalties or fees. The surrender fee is usually 10%–20% but can be as high as 35%–40%. Check with your policy contract.
How Much Will I Receive If I Surrender My Life Insurance Policy?
When you surrender your life insurance policy, you don't receive the death benefit, only the cash surrender value means any fees that are charged by your insurance company. Payments (minus the fees) from withdraws or loans on a life insurance policy generally are made within 14–60 days from the time the request is received.
When Should I Cash Out my Whole Life Insurance?
While it isn't always advisable to cash out your life insurance policy, many advisors recommend waiting at least 10 to 15 years for your cash value to grow. It may be wise to reach out to your insurance agent or a retirement specialist before cashing in a whole life insurance policy.
The Bottom Line
Economic trouble can prompt you to contemplate liquidating assets for cash. Sometimes you might have no other choice, but when it comes to life insurance, think about why you purchased the policy in the first place. Do you still need the coverage? Are the policy's beneficiaries depending on the death benefit if something happens to you? Consider the answers to these questions carefully.
Exploring other options such as a home equity loan or borrowing from your retirement account, or even your insurance policy, if you are allowed, might be worth investigating before you cash in a life insurance policy that you might want or need down the line.