Have you ever wondered if cashing out a life insurance policy is the right move? Life insurance policies can provide a financial cushion in times of need, but how do you know if it is the best option for you and your loved ones?
In this comprehensive guide, we’ll explore various cash-out options, their benefits and drawbacks, and the potential impacts on your policy’s benefits.
What life insurance policies have cash value?
If you have permanent life insurance, often called “whole life,” it likely came with a cash value component. Other, more complicated types of life insurance may accrue cash value as well, such as universal life (UL), variable universal life (VUL), and indexed universal life (IUL). If you’re unsure of what you have, you can check your policy or contact the issuing company or representative that sold you the policy.
Term life insurance does not have cash value, one of its main trade-offs, along with limited coverage. These two reasons are why term is less expensive than permanent coverage.
More: Term life vs whole life insurance: Key features, differences, ideal scenarios
Understanding life insurance cash-out options
Cashing out a life insurance policy is a decision that should not be taken lightly. There are three primary options to consider: policy loans, direct withdrawals, and full surrender. Each option has its advantages and disadvantages, impacting your policy’s death benefit, cash value, and overall financial performance.
Policy loans
A policy loan allows you to:
- Borrow against your life insurance’s cash value
- Access funds without affecting your coverage
- Potentially enjoy lower interest rates compared to many credit cards and personal loans, especially for universal life insurance policies and permanent life insurance policies
However, you must be aware of your borrowing limit to avoid policy lapsing due to excessive borrowing, which is especially common in whole-life insurance policies.
Another crucial factor to consider is the impact of a policy loan on the policy’s death benefit. If your beneficiaries depend on the death benefit to pay for final expenses, outstanding debts, or everyday living expenses, reducing the policy’s value may not be a wise decision. If you don’t repay the loan before your death, the loan amount and interest will be deducted from the death benefit payable to your beneficiaries.
Despite their benefits, policy loans have some drawbacks. Borrowers are subject to fees and interest charges on the cash value account, which can increase the amount owed.
Direct withdrawals
Direct withdrawals are known as a partial cash surrender. This option can be appealing if you need cash quickly but don’t want to jeopardize your coverage. However, it may reduce your death benefit, and you may have to pay partial surrender charges. To start a direct withdrawal, you’ll need to contact your insurance company and submit a request.
Withdrawals are typically tax-free up to the amount of premiums paid into the policy. However, withdrawing more than that amount may result in owing income tax on the gains. Don’t forget that this could lead to a reduced death benefit and the potential application of partial surrender charges.
Full surrender
A full surrender involves canceling your life insurance policy and receiving its cash value minus any applicable surrender fees. Consider this option carefully, as it may result in fees, tax implications, and the loss of life insurance coverage. A full surrender may not be the best choice unless you’re certain your beneficiaries no longer require the life insurance payout.
If you’re hesitant to surrender your policy entirely, other options are available. You could reduce the policy’s face value, use the cash value to convert the policy to paid-up status, or use the cash value to pay premiums temporarily.
Each alternative has advantages and disadvantages, so it’s important to consider your options and get advice from a financial professional before making a decision.
Evaluating the impact on life insurance benefits
Before surrendering your cash-value life insurance policy, it’s important to evaluate what you will lose. Withdrawing or reducing your cash value can lead to a lower death benefit—less money for your beneficiaries—and potentially a policy lapse, leaving you with inadequate coverage.
Before cashing out your life insurance policy, it’s vital to consider your unique financial situation and needs. If you have other life insurance policies or are considering a more cost-effective policy, cashing out one of your existing policies may not significantly reduce your coverage. Always consult with a financial advisor or insurance professional to fully understand the specific implications of cashing out a life insurance policy.
Tax implications
In some situations, cashing out life insurance can be a taxable event. It depends on the amount you receive, any gains, and dividends in the account. You may owe income tax on the gain if the payout exceeds the premiums paid.
The earnings portion of your withdrawal is subject to taxation at the prevailing income tax rate, while the basis (total premiums paid - previous withdrawals & dividends received) is tax-free. It’s essential to be aware of this when you pay taxes.
Consulting a financial professional before cashing out your life insurance policy can help you understand the potential tax implications and ensure you make the best decision for your financial situation.
How much will I get?
One of the biggest misnomers of surrendering permanent life insurance is that the policy owner will receive the death benefit. Rationally speaking, insurance companies wouldn’t be in business if this was the case. Aptly named, the “death benefit” is paid out to your beneficiaries when you die.
When you surrender your policy, you receive the cash surrender value—the cash value minus any fees from the issuer.
When is the best time to cash out?
There is no perfect time to cash out your whole life insurance policy. You bought the policy to take care of your loved ones, not to save for a rainy day. However, if you have no other choice, you should wait at least 10 to 15 years so your cash value has time to increase.
Alternatives to cashing out
It never hurts to weigh all of your options before making a financial move that can potentially harm your overall financial plan. As far as alternative options to cashing out your life insurance go, consider the following options with the help of a financial professional.
- Reduce your premiums: if affordability is the main issue, consider lowering your death benefit, which will lower your cost.
- Look into other financial solutions: a personal or home equity loan or a life settlement are all options that can provide financial relief without cashing out your policy.
Each alternative has advantages and disadvantages, so seek a financial professional’s advice before making a decision.
Keeping your life insurance intact: Premium payment strategies
If you want to keep your life insurance policy intact while accessing its life insurance cash value, some strategies can help. Using the cash value to cover premium payments or adjusting your policy’s terms can allow you to maintain your policy’s benefits without cashing out.
It is highly recommended that you request an “in-force illustration” from your life insurance company before withdrawing cash value from your policy. This illustration will help you understand the effect a withdrawal can have on your policy and provide valuable insight. This information will show how a withdrawal can affect your policy’s financial performance.
There are several strategic ways to utilize cash value for making premium payments, including:
- Increasing the death benefit
- Covering premiums
- Taking out a loan
- Executing a 1035 exchange for an annuity
- Reducing out-of-pocket premium costs by considering how much cash value is available
Final word
Cashing out your life insurance policy is a decision that should be carefully considered based on your financial situation, needs, and the potential impact on your policy’s benefits. By exploring various cash-out options, evaluating their impact on your policy, and considering alternative financial solutions, you can make the best decision for your unique circumstances.
Always consult a financial professional to fully understand the implications of cashing out a life insurance policy and ensure you make the right choice for your financial future.
Frequently Asked Questions
What happens when you cash out a life insurance policy?
Surrendering your life insurance policy is one option when cashing out. You’ll receive the cash value minus any surrender fees, but your policy will be terminated at that point. It’s important to ensure you and your beneficiaries are in good financial standing before making this decision.
Do you have to pay taxes when cashing out life insurance?
Generally, life insurance proceeds a beneficiary receives due to the insured’s death are not included in gross income and don’t have to be reported. Withdrawing up to the amount of premiums paid into the policy is also exempt from taxes. Any interest or gains on the policy may be taxable as ordinary income.
What are the main cash-out options for life insurance policies?
The main cash-out options for life insurance policies are policy loans, direct withdrawals, and full surrender.
How does a policy loan impact the death benefit of a life insurance policy?
When a policy loan is not repaid before the policyholder passes away, it will reduce the amount of death benefit payable to their beneficiaries.
