Cashing In On Life Insurance: Redeeming Your Policy

Life insurance can be cashed in while the policyholder is still alive, but this depends on the type of policy held. Term life insurance, which covers a person for a set period, cannot be cashed in, whereas whole life insurance and universal life insurance, which are permanent policies, can be cashed in. Cashing in a life insurance policy can be done in several ways, including withdrawing the entire cash value, making a partial withdrawal, or borrowing money from the policy. However, there are pros and cons to each method, and policyholders should carefully consider their options before proceeding.

Withdrawing your entire cash value

Surrendering your life insurance policy means cancelling it entirely and receiving a cash payment for the value of the policy minus any surrender fees. Surrendering a policy is considered a last resort as you will no longer have life insurance coverage, and the cash you receive will be lowered by any fees taken out. Surrender fees can be significant, especially for newer policies, and you may also have to pay taxes on any gains earned on the cash value portion of the policy.

If you want to surrender your permanent life policy because of the premium cost, you could consider using the cash value to cover your premium payments.

Before you surrender your policy, consider your overall financial plan and whether you have enough assets to leave behind for your dependents if you die.

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, often, on 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 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.

Making a partial withdrawal

A partial withdrawal of a life insurance policy allows you to release some of its cash value while keeping the policy in force. This means that the policy owner can remove some of the cash value from their policy without having to cancel the entire policy.

Understanding Partial Withdrawals

Partial withdrawals, also known as partial surrenders, are most commonly made when policyholders feel less concerned about their total death benefit and wish to use the accumulated cash value, or when a serious situation arises that requires the policy owner to find money to cover an obligation.

Types of Policies That Allow Partial Withdrawals

Universal life insurance policies and whole life insurance permit partial withdrawals. However, these two policy types have different rules regarding partial withdrawals:

• Universal Life Insurance: Policy owners can withdraw any cash surrender value whenever they want, and there is usually no waiting period. The death benefit may not change when a partial withdrawal takes place. However, pro-rated surrender charges may be applied if the withdrawal exceeds 10% of the net cash value of the policy.
• Whole Life Insurance: Policy owners can generally only withdraw cash value created through the elective paid-up additions rider or dividends used to purchase paid-up additions. They cannot withdraw cash value accumulated through the guaranteed accumulation of base whole life cash value. Whole life policy owners can, however, accept a partial reduction of the death benefit on their base whole life policies to achieve a partial withdrawal of the base guaranteed cash value.

Tax Implications of Partial Withdrawals

Partial withdrawals are generally not taxable as long as the amount withdrawn does not exceed the total amount of premiums paid into the policy. Withdrawals that exceed the total amount of premiums paid are treated as taxable income.

Other Considerations

It's important to note that a partial withdrawal will lower the cash value of the policy, and if the insured dies with an unpaid cash value balance, this amount will be charged against the death benefit paid out to the beneficiary. There may also be additional costs, such as processing and administrative fees, associated with making a partial withdrawal.

Borrowing money from your life insurance

Types of Policies

Only permanent life insurance policies, such as whole life or universal life insurance, build up a cash value that can be borrowed against. Term life insurance, on the other hand, is generally cheaper and only covers a predetermined amount of time, with no cash value component. In some cases, a term life policy can be converted into a permanent policy, allowing for the accumulation of cash value.

How it Works

The cash value in a permanent life insurance policy grows over time, typically taking several years to reach a substantial amount. Once you have sufficient cash value, you can borrow against it by taking out a loan from the insurer, with your policy serving as collateral. This means that the cash value continues to accumulate, and the loan is separate from the death benefit.

Interest and Repayment

Interest rates on life insurance loans are typically lower than those for personal loans or credit cards, ranging from 5% to 8%. While there is no strict repayment schedule, it is important to make regular payments to avoid accruing excessive interest. If the loan remains unpaid, it can cause your policy to lapse, and you may owe taxes on the borrowed amount.

Impact on Death Benefit

Borrowing against your life insurance policy will reduce the death benefit for your beneficiaries if the loan is not repaid. The outstanding loan balance, including any accrued interest, will be deducted from the death benefit. Therefore, it is crucial to consider the potential impact on your beneficiaries before borrowing from your life insurance.

Advantages and Disadvantages

Borrowing against your life insurance can provide quick access to cash without affecting your credit score. There is no approval process, credit check, or impact on your credit. Additionally, you have flexibility in when you repay the loan. However, there are also disadvantages to consider. You need to wait for the cash value to build up, which can take several years. If you don't make payments, you could lose your coverage, and your only options are typically whole or universal life insurance policies, which are more expensive.

Surrendering the policy

Surrendering your life insurance policy means telling your insurance company that you no longer want life insurance coverage. In exchange, you will receive a portion of the cash value of the policy, known as the cash surrender value. This is generally slightly less than the total amount of cash value in the policy because of surrender charges assessed by the policy.

Surrendering a policy can be a valuable source of quick cash for someone who doesn’t have access to other liquid assets and needs the life insurance money now. However, it is important to note that there are alternatives to a cash value surrender, including options that pay more.

How to Surrender Your Policy

To surrender your policy, you will need to sign a lost policy release (LPR) to surrender or cancel your policy. You can surrender part of the value in your policy while leaving the policy in force, or you can surrender the entire value and terminate the policy.

If you surrender the 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, often, on 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.

Reasons to Surrender Your Policy

The Coverage is no Longer Needed

If your policy’s beneficiary passes away before you, you may have no other person to name as their replacement. Alternatively, if you named your spouse as your beneficiary and are now getting a divorce, you may want to get rid of the policy.

To Get the Cash Value

When a policy is surrendered, the policy owner will receive all of the remaining cash value in the policy, known as the cash surrender value.

Less Expensive Coverage is Available

If your health has improved since you took out your last policy, it may be wise to surrender your current policy and take out new coverage.

Understanding Cash Surrender Value

The cash surrender value calculation is based on:

• The total amount of premium payments you made into the policy.
• The performance of the investments that the cash value is held in.
• Any applicable surrender fees.

The cash surrender value is, therefore, the amount of money you will receive after all surrender charges and administrative costs are subtracted from the policy’s cash value, and any outstanding loans are repaid.

Alternatives to Surrendering a Policy

There are several ways to access the cash value in your life insurance policy that don’t require you to surrender it. Here are some alternatives:

• Direct withdrawal: You take money out of your cash value but leave enough in the policy to keep it in force. You have to continue paying premiums, but you can keep the death benefit protection this way. The death benefit is reduced by the amount you withdraw.
• Policy loan: The most common way to access the cash value in your life insurance policy is to take out a loan using the policy as collateral. The interest on the loan is usually less than you would pay to other traditional lenders.
• Life settlement: The most profitable way to cancel your coverage. A qualified buyer purchases your policy and assumes the responsibility of paying the premiums. The buyer will then receive the death benefit when you die, and you will walk away with a lump sum upfront.

Selling the policy

Selling your life insurance policy can be a strategic way to unlock financial value, but it’s important to understand your options. There are two primary paths: a life settlement and a viatical settlement. Both allow you to sell your policy, but they’re designed for different situations and offer varying payout amounts depending on your policy type and health condition.

Life settlement

A life settlement is when a company that specializes in acquiring life insurance purchases your permanent or term life policy. The ownership of the policy changes, and the recipient transitions from your initial beneficiary to the life settlement company. The buyer then takes over the policy, including future premium payments, and expects a return on their investment. This means they will 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 a specialized type of life settlement 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. In a viatical settlement, the policyholder sells their life insurance to a third party, often with the help of a broker. The policyholder immediately receives a payout that’s less than the entire death benefit but typically more than a regular life settlement, because the payout is more immediate, due to the policyholder’s illness.

When the policyholder dies, the purchaser of the policy receives the full death benefit. The buyer therefore realizes a return on their investment: the difference between what they paid for the policy and the amount of the death benefit. The broker receives a percentage of that return, as compensation.

How to sell your life insurance policy

Selling your life insurance policy is a big decision, and getting the most value out of it requires careful planning. Here are some steps to follow to help you secure the best possible deal:

• Hire 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. By comparing several brokers, you can find one who is licensed in your state, offers fair commission rates, and is transparent about fees.
• Get multiple offers: If you’d rather not use a broker, you can go directly to life settlement providers. To make sure you’re getting a fair deal, it’s important to reach out to multiple providers and compare their offers.
• 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, so be prepared to sign a release granting them permission to obtain these records.

Tax considerations when selling your life insurance

Selling your life insurance policy can give you access to extra cash, but it’s important to understand the tax implications. The tax treatment differs depending on the type of settlement you choose, and can affect how much money you actually take home.

Viatical settlements

If you’re terminally ill and qualify for a viatical settlement, the money you receive is usually tax-free. This benefit is provided by the Health Insurance Portability and Accountability Act of 1996 (HIPAA), which ensures that people facing serious health issues can use their funds without worrying about taxes.

Life settlements

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 simplified breakdown:

• The portion of the sale amount that is equal to what you’ve paid in premiums (your “cost basis”) will generally not be taxed.
• The portion that exceeds your cost basis but is less than the cash value of the policy may be subject to income tax.
• Any amount above the cash value may be subject to capital gains tax.

Estate tax impact

Selling your policy and converting it to cash might also 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 who can help you navigate these considerations and determine the best course of action for your specific situation.

Should I sell my life insurance policy?

Deciding whether to sell your life insurance policy is a big decision, and it’s important to weigh the pros and cons before taking the leap. While it might make sense in certain situations, selling your policy isn’t the right choice for everyone.

Pros of selling your life insurance policy

• Immediate cash flow: Selling your policy can provide you with a lump-sum payment that can be used for any immediate financial needs, such as covering medical bills, paying off debt, or funding retirement.
• Relief from premium payments: If keeping up with monthly premium

Frequently asked questions