Cashing Out Partial Life Insurance: Is It Possible?

Life insurance can be a vital component of a comprehensive financial plan, providing financial protection to your loved ones after your death. But some types of life insurance policies also have cash accounts that can be tapped into while you're alive. Whether you can cash out your life insurance policy before death depends on what kind of policy you have. Term life insurance, for instance, does not qualify for cash-outs, as it is designed to cover you for a specified period and then ends. Permanent life insurance, on the other hand, often costs more but allows you to access the cash value. This includes whole life insurance and universal life insurance.

Withdrawing the full cash value

Surrendering your life insurance policy means cancelling it and receiving a cash value payment. This payment may be a lump sum or paid over time. Surrendering your policy will allow you to access a large portion of your cash value. However, you will no longer have life insurance coverage, so your beneficiary will not receive a death benefit.

If you surrender your policy during the early years of ownership, when the value is relatively low, the company will likely charge surrender fees, reducing your cash value. These charges vary depending on how long you've had the policy and the amount being surrendered. Some policies can levy surrender charges for many years after the policy is issued.

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 giving up 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.

Making a partial withdrawal

The amount you can withdraw will depend on the type of policy you have and the company issuing it. You can generally withdraw up to the amount you've paid in premiums without paying taxes on the funds. Withdrawing more than this may result in tax liabilities.

Partial withdrawals are a good option if you only need a small amount of cash and want to maintain your life insurance coverage. However, it's important to consider the reduced death benefit for your beneficiaries and any potential tax consequences before making a withdrawal.

Borrowing from the policy

Borrowing from your life insurance policy can be a quick and easy way to get cash. This option is available for permanent life insurance policies that have a cash value component, such as whole life, universal life, and final expense insurance. Term life insurance policies, on the other hand, typically do not have a cash value component, so you cannot borrow against them.

The cash value component of a life insurance policy is like a savings account that grows tax-free over time. A portion of your life insurance payment is put into this account, which accumulates interest. Over time, the cash value can grow to hundreds or thousands of dollars.

When you borrow against your life insurance policy, you are taking out a loan from the insurance company, with the death benefit and cash value of the policy used as collateral. There is usually no formal approval process for this type of loan, and you can often borrow up to 90% of the cash value of the policy. The interest rates on these loans are generally lower than those for personal loans or credit cards, typically ranging from 5% to 8%.

One of the benefits of borrowing against your life insurance policy is that it does not affect your credit score. Additionally, there are no restrictions on how you can spend the money. However, it is important to note that if you do not repay the loan before you die, the outstanding balance, including any accrued interest, will be deducted from the death benefit that your beneficiaries receive.

While borrowing from your life insurance policy can be a convenient way to access cash, it is not without risks. If you are unable to make the monthly loan payments, you may lose your life insurance policy. Additionally, if the loan is not repaid before the policy lapses, you may have to pay taxes on the amount borrowed.

Surrendering the policy

Surrendering your life insurance policy means cancelling your coverage in exchange for a lump sum of money. This is the cash surrender value, which is the money a life insurance policyholder receives for ending their coverage before the policy matures or before they pass away.

The cash surrender value is different from the policy's cash value, which is the total sum in the savings component of permanent policies like whole and universal life insurance. The difference is due to surrender fees, which are usually between 10-35%. Surrender fees are typically high in the early years of the policy and then gradually decrease over time.

Most policies have a waiting period of a few years up to 15 years before you have the option to surrender. If you surrender before the waiting period is over, you will have to pay higher surrender charges, which will reduce the cash surrender value you receive.

To surrender your life insurance policy, you will need to gather your policy documents, including the contract, amendments, and payment receipts. Then, notify your life insurance provider that you would like to surrender your policy. They will guide you through their process, which will typically include paperwork such as termination and surrender forms. The insurer will review the paperwork and process the request, which can take anywhere from 7 to 30 business days.

Once the surrender request has been approved, the insurer will pay you the cash surrender value through a check or direct deposit. The amount you receive will be the cash surrender value minus any surrender fees and outstanding debts if you had a loan on the policy. You may also have to pay income taxes on the proceeds if your payout exceeds the premiums you paid.

Pros

• Easy and fast: Surrendering your policy is a simple and quick process.
• Get some money back: You will receive a payout, which is better than getting nothing if you lapse your policy.

Cons

• Minimal return: Surrendering your policy means you'll only get one offer from the insurance company, and they will aim to give you as little money as possible.
• Surrender fees: Insurance carriers often charge fees for surrendering a policy, which can be up to 35% of the proceeds.
• Limited options: When surrendering a policy, there is no room for negotiation.

Selling the policy

Selling your life insurance policy can be a strategic way to unlock financial value, but it's important to understand the process and the two primary paths available to you. These are a life settlement and a viatical settlement, each designed for different situations and offering varying payout amounts depending on your policy type and health condition.

Life settlement

A life settlement is typically for policyholders aged 65 or older who are experiencing a health decline. It is best suited for permanent policies that accumulate value over time and are in higher demand. Term policies can sometimes be sold, especially if they're convertible to permanent coverage or if the insured is terminally ill. In a life settlement, you usually receive more than the policy's cash surrender value but less than its full death benefit. This is because the buyer takes over the policy, including future premium payments, and expects a return, so they offer a price that's profitable for them but higher than what you'd get by surrendering the policy.

Viatical settlement

A viatical settlement is specifically for those with a terminal illness and a life expectancy of less than 24 months. It generally offers a higher payout since buyers expect to collect the death benefit sooner. Payment amounts are regulated by state laws, ensuring that terminally ill individuals receive a fair percentage of the policy's value.

How to sell your life insurance policy

Selling your life insurance policy is a big decision, and it's important to carefully plan to help secure the best possible deal. Here are some steps to follow:

• Consider hiring an independent advisor: An advisor with expertise in life settlements can provide an accurate appraisal of your policy's value, help you understand potential tax consequences, and offer guidance throughout the process.
• Find a reputable, licensed broker: While a life settlement broker may charge a fee, they can often help you get the best possible offer by finding the highest bidder. Their commission is often tied to the sale price, and they have a fiduciary duty to work in your best interests.
• Get multiple offers: If you'd rather not use a broker, you can go directly to life settlement providers. While this might save you from paying broker fees, it could also mean receiving a lower offer since there's no competitive bidding process.
• Round up your paperwork: The selling process involves more than just your life insurance policy; your medical history plays a key role, too. Potential buyers will require access to your medical records to accurately assess your policy's value.

Tax considerations when selling your life insurance

Selling your life insurance policy can have tax implications, and it's important to understand how these taxes work. Depending on the type of settlement you choose, the tax treatment differs:

• Viatical settlement: If you're terminally ill and qualify for a viatical settlement, the money you receive is usually tax-free.
• Life settlement: When you sell a life insurance policy, the money you receive can be taxed in three different ways: as ordinary income, as long-term capital gains, or as tax-free income. Here's a breakdown:
• The portion of the sale amount you receive that is equal to what you've paid in premiums (your "cost basis") will not be taxed.
• The portion that exceeds your cost basis but is less than the cash value of the policy is subject to income tax.
• Any amount above the cash value is subject to capital tax gains.

Additionally, if you own your life insurance policy when you die, it's included in your taxable estate. Selling your policy and converting it to cash might reduce the value of your taxable estate, which could lead to lower estate taxes for your heirs. Given the complexities, it's always a good idea to talk to a tax professional for specific advice.

Frequently asked questions