Understanding Cash Out Life Insurance Policies: Pros And Cons

Cashing out life insurance refers to accessing the cash value of a life insurance policy. This is typically a feature of permanent life insurance policies, such as whole life or universal life insurance, where a portion of the premiums are put into a cash savings account, earning interest over time. This cash value can be accessed in several ways, including withdrawing funds, taking out a loan against the policy, or surrendering the policy entirely. It's important to note that cashing out life insurance may have certain consequences, such as reducing the death benefit for beneficiaries and potential tax liabilities.

Cashing out a life insurance policy before death

Types of Life Insurance Policies

There are two main types of life insurance: term life and permanent life. Term life insurance is designed to cover you for a specified period, such as 10, 15, or 20 years, and then ends. Permanent life insurance policies, on the other hand, provide coverage for your entire life.

Only permanent life insurance policies can build cash value. This includes "whole life", "universal life", "variable life", and "indexed universal life insurance". Term life insurance policies do not build cash value and therefore cannot be cashed out. However, some term policies can be converted into permanent policies that can be cashed out.

Options for Cashing Out a Life Insurance Policy

If you have a permanent life insurance policy that has accumulated cash value, there are several options for cashing it out before death:

• Full withdrawal: You can withdraw your entire cash value. This usually requires surrendering your policy, which means your coverage will end and your beneficiaries will not receive a death benefit. You may also have to pay "surrender charges" and income taxes on the money.
• Partial withdrawal: You can choose to withdraw only a portion of the cash value of your policy. This allows you to keep your policy active and provide a death benefit for your loved ones, although it may be smaller than originally intended.
• Borrowing: If you've had your life insurance policy for several years, you may be able to borrow money from your policy's cash value. This option usually doesn't incur taxes on the borrowed amount, but the insurance company will deduct interest payments from your cash value balance. If you repay the loan and interest in full before your death, your beneficiaries will receive the full death benefit.
• Surrendering the policy: You can surrender your policy and receive the full cash value, minus any surrender fees and taxes. However, this will cancel your coverage and your beneficiaries will not receive a death benefit.
• Selling the policy: You can sell your life insurance policy to a third party for a lump sum that is greater than the cash value but less than the death benefit. This is known as a "life settlement". After the sale, you will no longer be responsible for premium payments, and the buyer will receive the death benefit upon your death.
• Using living benefits: If you are diagnosed with a terminal illness and have a limited life expectancy, you may be able to access a portion of the death benefit early. This is known as a "living benefit" and can help cover medical costs.

Considerations

When considering cashing out a life insurance policy before death, it's important to weigh the pros and cons of each option. Here are some key points to consider:

• Tax implications: Withdrawing more than the amount you've paid in premiums may result in taxable income. There may also be taxes on any gains or earnings from the cash value portion of the policy.
• Reduced death benefit: Withdrawing or borrowing from your cash value will likely result in a reduced death benefit for your beneficiaries.
• Surrender charges: Surrendering your policy may incur significant fees, especially if the policy is relatively new.
• Future earnings: Accessing your cash value now may reduce the long-term growth potential of the remaining balance.
• No coverage: Surrendering or selling your policy means you will no longer have life insurance coverage.

Permanent life insurance policies that build cash value

Permanent life insurance policies, such as whole life and universal life insurance, are characterised by level premiums and a savings component. They are designed to cover the policyholder for their entire life, and they can build cash value over time. This cash value can be used for several purposes, including supplementing retirement income, covering college tuition, or making a down payment on a home.

Permanent life insurance policies are typically more expensive than term life insurance policies. This is because permanent policies provide coverage for the entirety of the policyholder's life, whereas term life insurance is designed to cover the policyholder for a specified period, such as 10, 15, or 20 years. Term life insurance generally costs less, but it does not build cash value in the same way that permanent policies do.

With permanent life insurance, a portion of each premium payment is allocated to the cost of insurance, while the remainder is deposited into a cash value account. This cash value account earns interest, and taxes on the accumulated earnings are deferred. As the cash value increases, the insurance company's risk decreases because the accumulated cash value offsets part of the insurer's liability.

There are several types of permanent life insurance policies that build cash value, including:

• Whole life insurance: This is one of the most popular choices in the life insurance market. Whole life insurance is characterised by regular, fixed premium payments. The cash value of whole life insurance can grow with potential tax savings, and the death benefit is guaranteed as long as premiums are paid.
• Universal life insurance: Universal life insurance plans allow the policyholder to change the value of premium payments, providing adjustability. The cash value of a universal life insurance policy can be used to pay premiums or other expenses as needed.
• Variable life insurance: Variable life insurance provides greater access to investment tools, and the cash value will grow or diminish depending on the performance of the chosen investments.
• Indexed life insurance: This type of policy has a greater relationship with the stock market, as the chosen index's performance directly impacts the rate of return on the cash value.

The cash value component of permanent life insurance policies offers flexible access to funds. Policyholders can take out a loan against the policy, make a partial or full withdrawal, or surrender the policy for its cash value. However, it is important to note that accessing the cash value of a permanent life insurance policy may result in surrender charges and tax implications, and it will also reduce the death benefit for beneficiaries.

Pros and cons of cashing out a life insurance policy

Pros of Cashing Out a Life Insurance Policy:

• You can immediately use the funds for current living expenses such as retirement, healthcare expenses, or long-term care.
• If you surrender or sell your policy, you stop paying costly premiums.
• Cashing in your life insurance policy does not affect your credit score since it is not a loan or line of credit.
• Taking out a loan against your life insurance policy can be a way to consolidate debt and lower your interest rates.

Cons of Cashing Out a Life Insurance Policy:

• Cashing in your life insurance policy can result in a lower payout or no payout at all to your beneficiaries.
• You may need to pay taxes on the proceeds you receive when cashing in your life insurance policy, especially if the policy's cash value exceeds the total amount of premiums paid.
• When you cash in your life insurance policy, you may no longer have coverage for your loved ones, which means you'll need to find another way to protect them in the future if they're still dependent on you.
• If you surrender your policy or withdraw cash from the cash value account before a certain period, you may have to pay penalties or surrender charges.

How to cash out a life insurance policy

Cashing out a life insurance policy is dependent on the type of policy you have. Term life insurance, for example, is designed to cover you for a specified period, such as 10, 15, or 20 years, and then ends. Whole life, universal life, and other permanent life insurance policies, on the other hand, are designed to cover you for the rest of your life and allow you to build cash value.

If you have a permanent life insurance policy, you can access the cash value in several ways:

Withdraw your entire cash value:

You can choose to cash out your whole life policy entirely, giving you access to all the cash value you've accumulated. However, this option requires you to surrender your policy, which means your coverage will end, and your loved ones will no longer receive a death benefit when you pass away. Additionally, you may have to pay "surrender charges" and income taxes on the money you withdraw.

Make a partial withdrawal:

Another option is to withdraw a portion of your policy's cash value while keeping your policy active. This allows your loved ones to still receive a death benefit, although it will likely be smaller than originally intended. You will need to check if the money you withdraw is taxable.

Borrow money from your policy:

If you've had your life insurance policy for several years, you may be able to borrow money from its cash value. In most cases, you won't have to pay taxes on the borrowed amount, and the interest charges are typically lower than those on credit cards or bank loans. However, if you don't repay the loan and interest in full before your death, the outstanding balance, plus interest, will be subtracted from the death benefit.

Surrender your policy:

You can choose to surrender your policy and withdraw its entire cash value. This option will also end your coverage, and your beneficiaries will no longer receive a death benefit. Additionally, you may have to pay surrender charges and income taxes on any gains earned on the cash value portion of the policy.

Sell your policy:

You can sell your life insurance policy to a third party for a lump sum that is greater than its cash value. This is known as a life settlement. While you'll continue making premium payments, the death benefit will go to the third party when you pass away.

It is important to carefully consider your options and understand the pros and cons of each before deciding to cash out your life insurance policy.

Alternatives to cashing out life insurance

If you're looking for alternatives to cashing out your life insurance policy, there are several options to consider. These alternatives can provide you with the money you need without risking your life insurance coverage. Here are some options to explore:

• Home Equity Loan: If you own a home, you can access its equity through a home equity loan. This allows you to borrow against the value of your property and receive cash. However, be sure to understand any fees and closing costs associated with this option.
• Cash-Out Refinancing: This option involves taking out a new mortgage that is larger than what you currently owe on your home. You can then receive the difference as cash.
• Reverse Mortgage: If you are 62 or older and have paid off most or all of your mortgage, a reverse mortgage might be a viable option. This allows homeowners to tap into their home's equity tax-free by receiving regular payments or a lump sum.
• Personal Loan or Credit Card: If you don't own a home, applying for a personal loan or using a credit card could be a good choice. Depending on your credit score, you may be able to secure a loan or credit card with a competitive interest rate.
• Retirement Accounts: If you're approaching retirement, consider whether your retirement accounts allow early withdrawals. For example, with a 401(k) account, you can typically start withdrawing at age 59½.
• Non-Retirement Investment Accounts: If you have investments outside of retirement accounts, you can sell assets at any time and withdraw funds to cover expenses. Keep in mind that you may owe taxes on these transactions, typically at long-term capital gains rates if you held the assets for over a year.
• Reduce Premiums: If affordability is the main concern, consider lowering your death benefit, which will result in lower premiums.
• Life Settlement: Instead of cashing out your policy, you can sell it to a third party through a life settlement. This typically requires you to be a certain age or have health impairments. You'll receive a lump sum that's greater than the cash value, but less than the death benefit. The buyer will then take over premium payments and receive the death benefit when you pass away.

Frequently asked questions