If you are one of 25 million Americans over the age of 60 who are economically insecure, cashing out your life insurance policy may be a much-needed financial boost in your life.
Depending on the value of the policy, the monthly premiums, and how many years you’ve held it, the cash payout of your policy can be anywhere from $3,000 to over $300,000. However, despite the benefits of a payment this large, it’s important to understand what it means to cash out life insurance, and how your individual circumstances will be affected.
To help our readers out, we put together a comprehensive guide of how to cash out life insurance. Read below to find out more.
What does it mean to ‘cash out’ life insurance?
When you hear the phrase ‘cash out life insurance,’ what you’re hearing referenced is the ability to withdraw or partial withdraw the cash value from your life insurance policy in exchange for sacrificing some, or all of the policy’s future value.
There are four main ways to cash out life insurance:
- Accepting the policy’s cash surrender value
- Cash value withdrawals or partial withdrawals from a policy’s savings component
- Borrowing against the value of a policy
- Selling an active life policy in a life settlement transaction
All of these methods have their own specific benefits and uses, and it makes sense to understand the application of each. Ultimately, you are trying to maximize the amount of money you receive in a way that makes sense for your personal finances and supplements your retirement income.
What’s the difference between a policy’s ‘cash value’ and its ‘face value’?
Before reading this self-help article, it’s important to understand the difference between the terms “face value” and “cash value.”
The face value of a policy (also sometimes referred to as the coverage amount) is the amount beneficiaries will be paid in the event of the death of the policyholder. For instance, if your life insurance policy has a face value of $1 million, your beneficiaries will receive a death benefit of $1 million upon your passing.
The cash value component of a policy, refers to a savings component inside of a whole or universal life insurance policy. Unlike the policy’s face value, a policy’s grows over time and can be withdrawn while the policyowner is still alive.
The cash value of a policy will almost always be less than the face value of a policy, unless a policyholder has paid enough premiums over many years and accumulated cash value grows to equal the coverage amount.
What type of life insurance policy do I have, and does it matter?
When it comes to cashing out your life insurance policy, the type of policy you have makes a tremendous difference.
For the purposes of cashing out, the two main types of life insurance products are worth differentiating: “term life insurance” and “permanent life insurance”.
The primary difference between these two types of insurance is that term life policies do not build cash value, whereas permanent life insurance policies do. For this reason, permanent life insurance policies can also be referred to as “cash value life insurance policies.”
- Whole life insurance, the most common type of life insurance, is a form of permanent life insurance. So too, are universal life insurance policies and variable universal life insurance.
- Universal life policies are flexible premium policies that pay interest in correlation with prevailing interest rates. Variable universal policies have all of the same characteristics as universal policies except that the cash value is invested in a mutual funds that rise and fall in value in tandem with the financial markets.
The growth in the cash value of your life insurance policy is tax-deferred, meaning you do not pay income taxes on the annual increases in your account. When considering the options for cashing out your life insurance you’ll want to understand both whether your policy is a permanent or term life policy, and what the policy’s values are.
Four main ways to cash out life insurance
As we mentioned above there are four primary ways to access the cash value of your life insurance policy. A simple way to think of this is surrender, withdraw, borrow or sell.
The amount of cash, the tax implications, policy status all differ based on what option you choose, as well as the process and institutions you may interact with.
1. Surrendering your life insurance policy
When you surrender your life insurance policy, you agree with the insurer to forfeit the entire policy’s death benefit in exchange for a cash payment, referred to as the policy’s cash surrender value. The cash surrender value is equal to the account value less a surrender charge. Surrendering a policy means a policy is canceled. You no longer make any premium payments, however, your beneficiaries also receive no payout in the event of your passing.
When surrendering your life insurance policy, it’s important to keep in mind that you are most likely facing a net loss of money — the amount you will have paid in premiums will be more than the amount you receive from the cash surrender. This is almost always the case for anyone surrendering their policy in under 20 years from when the policy was issued.
Cash surrender fees
It’s also important to keep in mind that by surrendering life insurance you may incur cash surrender fees, which are additional charges for canceling a policy early. This is primarily only applicable for individuals with a whole life insurance policy.
Cash surrender fees are designed to compensate the insurance company’s bottom line if premium payments are canceled prematurely. Due to how life insurance works, surrender fees often decline over time so that eventually (usually in 10-20 years) the cash surrender value equals the cash value.
For instance, it’s typical for a life insurance policy to have a 10% cash surrender fee which is paid if a policy is canceled year one—with fees decreasing by 1% each year after. After 10 years, there is no longer any penalty for canceling your policy. This is also known as exiting the cash surrender period.
Amount received in cash surrender
The amount you receive in a cash surrender differs based on how long you’ve had the policy active. For instance, in a whole life policy, where your payout is based on the cash component of your policy, you can expect to receive an amount based on the amount you have paid down.
Broadly speaking, if you’ve held a policy for less than 20 years, the cash surrender value will most likely be less than the face value of the policy. Typically an amount equivalent to a third or less of the premiums you paid.
Keep in mind you will also need to pay any applicable cash surrender fees, and taxes on any amount of the cash surrender value in excess of what you paid in premiums. These can start to eat away at the value.
Oftentimes the best way to get the most cash for your policy is to sell it in a life settlement, which we’ll cover below.
2. Withdrawing from the cash value of a policy
If you want to access some of the savings component inside a permanent life insurance policy while still keeping the policy active, it’s possible to withdraw some of a policy’s cash value without surrendering it completely.
When exercising an early cash withdrawal, it’s important to consider that you may face increased monthly premiums, a decreased death benefit, or both. This is because due to the way insurance companies work, your cash value component is used to protect the insurance company’s bottom line, so as you adjust the amount reserved in your policy, so too will they adjust the other components of your policy.
Taxes and fees for early withdrawal
Due to their nature, withdrawals from life insurance policies tend to be largely tax-free. You are essentially withdrawing your own money, similar to a savings account.
However, similar to cash surrenders, you will have to pay income tax on any additional amount above the amount paid in premiums. If you’re wondering how a policy can have more cash savings than what you paid in, it’s because that cash component was accruing value through either interest, dividends or stocks. This amount gained will be taxed as regular income.
However, similar to cash surrenders, you will have to pay income tax on any additional amount above the amount paid in premiums. If you’re wondering how a policy can have more cash savings than what you paid in, it’s because that cash component was accruing value through either interest, dividends or stocks. This amount gained will be taxed as regular income.
Modified endowment contracts
If your policy has a very large cash value component, your life insurance policy may be classified and taxed as something known as a “Modified Endowment Contract,” or MEC. In a MEC, you will be required to pay a 10% early withdrawal penalty if you are under age 59 ½. However, this is something designed to prevent tax avoidance, and it is unlikely you will have to face this issue without getting help from an accountant.
3. Borrowing against the value of your policy
Another good option for cash is to borrow against the value of your policy, in what’s known as a policy loan.
In a policy loan, instead of borrowing from a bank or other financial institution, you are borrowing directly from the cash value of your policy. You may borrow in the form of a monthly or annual annuity in most cases if you like. Your insurance company will tell you how much you may borrow without causing the policy to lapse.
The two reasons an individual may choose to pursue a policy loan is there are no underwriting requirements to be approved, and you may receive favorable interest rates as your loan is backed by a collateral asset. This is a particularly favorable option for those who have poor credit, as they will be able to borrow a much larger loan amount against the value of their policy, compared to anywhere else.
If you fail to repay any outstanding loan balance in a policy loan, that amount will be deducted from the cash value or death benefit of your policy. This will include any interest on the loan amount. A policy loan still keeps your policy active.
Again, if your policy is classified as a MEC, then the loan amount will count as ordinary income, which incurs a 10% penalty if you withdraw the funds before you reach age 59 ½.
4. Selling your policy in a life settlement transaction
The final option if you’re looking to receive cash in exchange for your life insurance policy is to sell it in what’s known as a “life settlement.’
Unlike a policy that is canceled for its cash value component, a life settlement keeps a policy active, but “sells” the death benefit to a third party in exchange for lump sum payment.
When this happens, the purchasers of your life policy, also known as life settlement companies, agree to assume the policy’s premiums and policy benefit, in exchange for paying you some portion of the policy’s face value. This is in contrast to a cash surrender, which is paid by the life insurance company that issued you your policy.
Life settlement transactions typically pay many times more than a policy’s cash surrender value, yet once again in permanent life insurance this depends on how long you’ve had the policy and how much value it has accrued. However, a life settlement transaction will always pay more than canceling a term life insurance policy, as letting a term policy lapse will yield no money.
Should you cash out your life insurance policy?
The answer to this question is complex and we highly recommend discussing any decisions regarding life insurance to involve both a financial advisor, as well as any loved ones who will be affected by the decision.
The most simple answer is you should cash out your life insurance policy only if you cannot afford the insurance costs or are in immediate need of cash or at risk of letting your policy lapse. If you simply cannot afford to pay your life insurance premiums anymore, it doesn’t make much sense to endanger other financial needs in your life, especially medical or long term care. Also, if you have a terminal illness and are in need funds to cover unexpected medical expenses.
The final reason you may want to cash out your policy is you simply no longer need life insurance coverage. If your intended beneficiary is no longer in the picture, and you don’t need to look out for someone’s financial wellbeing after your death or the original reasons that your took out the insurance policy in the first place no longer exist (mortgage paid off, college tuition paid already, etc.), you may want to access the value accrued in your policy.
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If you’ve read this article you understand the primary tenets of cashing out life insurance, including the ways to do so, the tax implications, fees and whether or not your policy will stay active. The decision on what to do will ultimately be a personal one.
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- If you are interested in selling your policy for cash, we recommend checking out many of our helpful guides on life settlements.
- If you wish to cancel the policy, we recommend reading up on a policy’s cash surrender value.
- If you are terminally ill, we highly recommend looking into a viatical settlement, as you may be eligible to receive even more money than in the options laid out above.
You can also find out more about life settlements from your financial advisor or life insurance agent. They can also give you life insurance quotes and help you with other aspects of financial planning, such as growing an IRA or helping you determine the right type of life insurance based on your life expectancy. This is true even if you live in New York and pay taxes there. But the policy premiums may be different than if you lived anywhere else.
Want to find out how much your life insurance policy is worth? Find out in seconds with our free life settlement calculator. At Q Capital, we’re committed to helping you get the best settlement possible offer for your life insurance policy. Reach out to our knowledgeable and friendly team today – call us at 866-679-9410 or book an appointment – to get started; we would be happy to walk you through the process and take the time to answer any questions you have!
