Understanding Cash Value Life Insurance Payouts For The Insured

Cash value life insurance is a type of permanent life insurance that includes a cash value feature. This means that a portion of the policyholder's premium payments accumulates over time and can be withdrawn or borrowed against to cover significant expenses. The cash value of a life insurance policy can be accessed in several ways, including direct withdrawals or by taking out a loan against the value of the account. However, it's important to note that if the policyholder withdraws money directly and doesn't pay it back, the death benefit payout will be reduced by the withdrawn amount. Additionally, most cash value insurance policies do not add the cash value account to the death benefit, meaning that if the policyholder does not use the cash value while alive, the money will revert to the insurance company rather than going to the beneficiaries.

Borrowing against life insurance

When borrowing against a life insurance policy, there is no approval process or credit check. The only requirement is that you have sufficient cash value to borrow against. The minimum amount varies by insurer but is typically no more than 90% of the policy's cash value. Interest rates for life insurance loans are generally lower than those for personal loans and credit cards, and there is no mandatory monthly payment. However, it is important to pay the loan back in a timely manner on top of your regular premium payments. If unpaid, interest is added to the balance and can cause the policy to lapse. In this case, you may owe taxes on the amount borrowed.

Pros

Cons

If you do not pay back the loan, the death benefit will be reduced, and your beneficiaries will receive less. There is also a risk of the policy lapsing or being cancelled if the loan amount plus interest accrued is more than the policy's current cash value. There may also be potential tax implications if the coverage lapses.

Withdrawing cash from a policy

Withdrawing cash from a life insurance policy is a serious decision that should not be taken lightly. It is important to understand the implications and the pros and cons of doing so.

Withdrawing Cash

Withdrawing cash from a life insurance policy is possible, but it is important to note that this will reduce the death benefit for your beneficiaries. Withdrawing cash can also have tax implications. If you withdraw more than the amount you have paid into the policy, that portion may be taxed as ordinary income. Therefore, it is generally recommended to withdraw only up to the amount you have contributed to the policy.

Borrowing Cash

Another option is to borrow cash from the insurer, using your policy as collateral. This option typically has lower interest rates compared to personal or home equity loans, and there is usually no loan application or credit check required. However, interest charges may apply, and any unpaid balance will reduce your benefits. It is important to carefully consider the potential impact on your beneficiaries before borrowing against your life insurance policy.

Surrendering the Policy

You also have the option to surrender your insurance policy, which means cancelling it and receiving the surrender value in cash. This option provides a lump-sum payment, but it comes with surrender fees that will reduce the cash you receive. Additionally, your beneficiaries will not receive a death benefit from the policy upon your death.

Selling the Policy

Selling your life insurance policy to a third party, such as a life settlement company, is another way to access cash. This option provides a lump-sum payment, and you will no longer owe premiums on the policy. However, your heirs will not receive a death benefit, and you may owe taxes on the sale. There are also restrictions and qualifications for selling a life insurance policy, such as age or health conditions.

Weighing the Options

Before making a decision, it is crucial to understand the implications of each option and how they align with your personal and financial goals. Consult with a financial advisor or a tax professional to fully understand the tax and financial implications of withdrawing cash from your life insurance policy.

Surrendering a policy for cash

Surrendering a life insurance policy means cancelling the policy and receiving its surrender value, which is the cash value minus any surrender fees. If you go down this route, the coverage ends, and your beneficiaries will not receive a death benefit when you die.

You'll owe taxes on the amount you receive that's above the cost basis. Surrendering your policy may trigger tax consequences if any of the following occur:

• You receive more funds than the policy's cost basis.
• You have outstanding policy loans that exceed the policy's cost basis. The insurance company will deduct the loan amount and any interest from the cash surrender value. You'll owe income tax on the lower surrender value if it exceeds the amount paid in premiums.

Review your life insurance policy documents:

Gather your policy documents, such as the contract, riders, amendments, and premium payment receipts. Look for wording about cash surrender value, surrender charges, and other surrender-related terms in your documents.

Speak with your insurer:

Inform your life insurance provider's customer service that you'd like to surrender your life insurance policy. They will guide you through the process of surrendering the policy and paying the cash surrender value.

Fill out the paperwork:

Your insurer may give you a policy termination form, surrender request form, or similar paperwork. Complete these forms, providing all the information and documentation requested.

Receive the cash surrender value:

Your insurer will process your surrender request and determine the proper cash surrender value based on the policy's terms. They will then pay you that amount via check or direct deposit.

Consult with a tax expert and financial advisor:

Receiving a large payout could trigger tax consequences, so consult a tax expert to report everything properly. Furthermore, you may consider saving or investing your funds elsewhere. A financial advisor can help you pick the best place for these funds.

When to surrender your life insurance policy

There are several scenarios in which it may make sense to surrender your life insurance policy for cash.

You found a better deal:

Although life insurance quotes rise with age and new health issues, you may be able to qualify for a more affordable policy now than when you first took out your current one. For example, your health may have improved significantly, or you may have quit smoking. In this case, it may be worth shopping around for a new, cheaper policy before surrendering your current one.

You can't afford the premiums:

Permanent life insurance is significantly more expensive than term life insurance. If the premiums are straining your finances, you may be better off with a cheaper term life policy.

You no longer need life insurance:

There may be instances when you simply no longer need life insurance coverage. For example, if no one depends on you financially anymore, you may not need life insurance, and it may not make financial sense to keep your policy in force.

You need a large amount of cash quickly:

If you have a major expense to cover or a better investment opportunity but don't have any liquid assets to tap into, surrendering a cash-value life insurance policy may be a decent option, especially if your actual need for life insurance has diminished.

Partial withdrawals

• Availability and Limitations: Not all cash value life insurance policies allow withdrawals. For example, certain types, such as universal and traditional whole life policies, may not permit any withdrawals. Policies that do allow withdrawals often have restrictions on the frequency and amount that can be withdrawn. Some policies may impose a maximum withdrawal limit, such as $500 per withdrawal.
• Tax Implications: Withdrawing up to the amount you've paid in premiums (your basis in the policy) is typically not subject to income tax. However, if you withdraw more than your basis, the portion that exceeds it will likely be treated as taxable income. Withdrawals that include investment gains or earnings are generally taxable.
• Impact on Death Benefit: Withdrawing money from your cash value life insurance policy will usually result in a reduction in the death benefit. The reduction may be greater than the amount withdrawn, depending on the specific terms of your policy. It's important to carefully review the details of your policy or consult with your agent or insurance company to understand how withdrawals will affect your death benefit.
• Timing and Growth: It's important to consider the timing of withdrawals. Withdrawing money too early may result in lower cash value and could lead to increased premiums or policy lapse. Allowing the cash value to grow over several years can provide a more substantial sum for future use.
• Alternative Options: Before making a partial withdrawal, consider other options available to you. For example, you may be able to borrow against the cash value or use the cash value to pay policy premiums. These alternatives can help you access funds while maintaining the full death benefit.

Using cash value to pay premiums

Cash value life insurance policies provide lifelong coverage, with an investment account component. Whole life, universal life and variable life policies are all types of cash value life insurance.

When you make a premium payment, the money is split into three categories: the cost of insurance, fees and overheads, and the cash value. The cash value is separate from the death benefit, and your beneficiaries will not receive it when you pass away.

The cash value of a life insurance policy can be used to pay premiums. Variable and universal life insurance policies are often favoured for this, as they allow the policy's cash value to be used to pay premiums. This strategy will only work in the short term if you start when the cash value is small or interest rates are low. You will need to monitor the cash value to make sure it doesn't drop too far, or you may lose your coverage. However, if you have a large cash value with consistent returns, you can keep coverage in place for years at little to no additional cost.

For example, if your annual premium is $5,000 and you have $100,000 in cash value, you would need the policy's cash value to net 2.5% interest annually to cut your premium payments in half while maintaining the full cash value.

Whole life insurance policies typically don't let you pay premiums using the policy's cash value, except if you convert to a paid-up policy. Not all insurers offer this option, but with a paid-up life insurance policy, the cash value is large enough that you can stop paying premiums out of pocket. The downside to this is that each premium payment is then deducted from the policy's death benefit, and less cash value is available for other purposes, such as a policy loan.

Frequently asked questions