Cashing In Your Life Insurance Policy
If your bills are piling up on you and you need to get your hands on some cash immediately, then cashing in your life insurance policy may be an option. This would generally only work with some form of cash value policy, such as a whole life or universal life policy or even a variable policy in some cases. But there are usually some definite disadvantages for those who choose to cash in their policies instead of accessing the cash in them in some other way. For one thing, the insured will forfeit the death benefit in the policy if he or she cashes it out completely. This may not be a good thing if the insured still has major debts to pay off, such as student loans or a mortgage. And cashing out a permanent life insurance policy can also have tax ramifications.
How You Can Access the Cash in Your Permanent Life Insurance Policy
Permanent life insurance, such as whole life and universal life, accumulates cash in a cash account from premiums paid and interest or dividend earnings. There are four methods that you can use to access the cash that you have accumulated in your permanent life policy.
This is perhaps the most straightforward method of taking money out of your permanent insurance policy. With this method, the insured simply contacts the insurance carrier and requests a disbursement of cash. The cash is then issued forthwith to the insured. The amount of cash that can be taken from the policy depends on the size of the policy, the amount of cash value in the policy and the specific life insurance carrier.
One of the chief advantages of this form of policy withdrawal is that all cash value that is drawn out of the policy is considered a tax-free return of principal up to the policy’s cost basis.
However, this rule may not apply if the policy being accessed is a MEC (Modified Endowment Contract). If this is the case, then all withdrawals from the MEC are taxed on a Last-in, First-out basis (LIFO), the same as with an annuity payout. And any withdrawals from a MEC taken before the insured is age 59 ½ can result in taxation plus a 10% early withdrawal penalty from the IRS.
Other factors to consider here are than the withdrawal of cash value in the policy could lower the policy’s death benefit, since all outstanding loans and other forms of withdrawal from a policy are usually subtracted from the death benefit before paying a claim to the beneficiary. And if the withdrawal is enough to lower the policy’s death benefit during the first 15 years of the life of the policy, then it may also trigger a taxable event. All cash withdrawals from a permanent life insurance policy are considered to be taxable income to the extent that they exceed the policy’s cost basis.
Furthermore, if the cash withdrawals are large enough, they could cause the remaining cash value in the policy to shrink to a point where the policy premiums must be increased in order to keep the policy in force.
This is perhaps the most popular way of accessing the cash value in a permanent insurance policy because taking out a loan will not cause the policy to lapse the way a direct withdrawal might. Policy loans are taken out of a permanent insurance policy using the cash value account in the policy as collateral. Most insurance carriers charge some level or form of interest on policy loans, but the insured does not have to financially qualify for the loan the way they would with a personal loan or other type of cash advance from a lender.
The amount that the insured can borrow depends on a few different factors, such as the loan terms set forth by the insurance carrier and the amount of cash value in the policy. Policy loans are also always tax-free, and the insured does not ever have to repay the loan despite the fact that it is charging interest to the policy’s remaining cash value.
But, as with straight cash withdrawals mentioned above, policy loans can also reduce the death benefit of the policy by the total amount of loans that have been withdrawn from the policy. And any policy loans that are taken from a MEC are considered to be taxable distributions in the eyes of the IRS, and the 10% early withdrawal penalty may apply depending upon the age of the insured.
Surrendering the Insurance Policy
This is usually advised against by most financial planners and life insurance agents because there can be tax ramifications, and the insured also forfeits the death benefit in the policy as mentioned previously. There can also be stiff penalties if the policy is surrendered during the early years of cash value accumulation (and this is almost always the case).
This form of policy surrender is much more palatable to financial planners and other professionals because the insured will usually receive far more cash from this type of surrender than with any other method. Life settlements are often done by older owners of large cash value policies that need cash now to pay medical or other bills.
A life settlement transaction is simply the direct sale of a life insurance policy for cash, either to another individual or (much more commonly) a life settlement company. The buyer is named as the new beneficiary on the policy, and the insured receives a lump-sum of cash up front. The buyer then assumes the responsibility of paying the premiums on the policy and then recouping its money when they receive the death benefit.
In general, any gain that the seller receives from the policy sale that exceeds the policy’s cost basis is taxed as ordinary income. However, calculating the exact income tax liability on this type of transaction can be tricky, so most planners advise their clients who do this to consult with a qualified tax expert. In most cases, the insured has to have a life expectancy of no more than 10 to 15 years, be at least 65 years old and own a policy with a death benefit of at least $100,000. And even term insurance can qualify for a life settlement in some cases. But those who find this type of transaction appealing need to stop and consider the following factors:
- Permanent forfeiture of the policy’s death benefit
- An obligation to furnish all past medical and health records to the buyer, as well as continuing to supply these on an ongoing basis
- Miscellaneous taxes, fees and commissions that can easily equal up to 30% of the policy’s death benefit, which means that the insured will be paid that much less
- Even though the industry has become a great deal more organized and regulated in recent years, it can still be difficult for insureds to know whether they are really getting a fair price for their policy
The Bottom Line
There are several different ways that you can access the value in your life insurance policy, but some ways are usually better than others. Policy owners may also want to consider borrowing from their 401(k) plans or taking out a home equity loan instead of raiding their policy’s cash value. For more information on taking cash distributions from your life insurance policy, consult your financial advisor.