How to Cash Out a Life Insurance Policy

How to Cash Out a Life Insurance Policy: 5 Ways

Life insurance policies aren’t only about providing for your loved ones when you pass away. Many policies, especially permanent ones like whole life or index universal life, allow you to access cash during your lifetime. If you're looking to learn how to cash out a life insurance policy, this article explains five ways to do so, with Capital for Life's recommendations of the pros and cons for each method.

What Does It Mean to Cash Out a Life Insurance Policy?

Cashing out a life insurance policy means accessing the cash value that has built up in certain types of permanent policies. This cash value accumulates over time as you pay premiums, and it can be accessed in various ways, such as by making withdrawals, borrowing against the policy, surrendering the policy, selling it, or using premium financing. Each method has its benefits and drawbacks, which we’ll explore in detail.

Reasons to Cash Out a Life Insurance Policy

Many policyholders choose to cash out their policies when they:

No longer need the death benefit, perhaps because beneficiaries are no longer financially dependent.
Face financial hardship or have large, unforeseen expenses (such as medical bills or home renovations).
Want to reduce or eliminate premium payments.
The policy has outlived its usefulness, or they want to explore alternative financial opportunities.

It's important to consider these reasons carefully, as cashing out often means giving up the death benefit, potentially leaving your loved ones without the financial protection you initially intended.

1. Withdraw from Your Policy

How It Works:
Some policies allow you to withdraw a portion of the cash value without completely surrendering the policy. This method gives you access to a portion of the cash while keeping the policy intact, albeit with a reduced death benefit.

Pros:

Withdrawals are tax-free up to the amount of the premiums you’ve paid.
You keep your policy in force.

Cons:

Withdrawals reduce the death benefit, potentially leaving less for your beneficiaries.
If the withdrawal exceeds the premiums paid, the excess might be taxable.

Capital for Life Recommends this is Best For:
Policyholders who need smaller sums of cash but want to keep the policy active for their beneficiaries.

2. Borrow Against Your Policy

How It Works:
You can take out a loan against the cash value of your policy, using the cash accumulation as collateral. No credit check is required, and repayment is flexible—you can even choose not to repay, though this reduces the death benefit by the loan amount plus interest.

Pros:

Loans are typically tax-free.
No need to pass a credit check.
Flexible repayment options.

Cons:

Interest accrues on the loan, and unpaid loans reduce the death benefit.
If the loan plus interest exceeds the cash value, the policy may lapse.

Capital for Life Recommends this is Best For:
Individuals who need a significant amount of cash and are confident they can repay the loan or accept a reduced death benefit.

3. Surrender Your Policy

How It Works:
Surrendering your policy means giving it up in exchange for the cash surrender value. This is usually a last-resort option because it cancels the policy, and the death benefit is forfeited.

Pros:

You receive the full cash surrender value.
No loan repayment or restrictions on how the funds can be used.

Cons:

You lose the life insurance coverage, and your beneficiaries will not receive a death benefit.
Surrender fees may apply, especially during the early years of the policy.
The cash surrender value could be taxable if it exceeds the premiums paid.

Capital for Life Recommends this is Best For:
People who no longer need life insurance and prefer to access a lump sum of cash immediately.

4. Sell Your Policy (Life Settlement)

How It Works:
A life settlement involves selling your policy to a third party. You receive a cash payment, typically more than the cash surrender value but less than the death benefit. The buyer takes over paying premiums and eventually collects the death benefit.

Pros:

You usually get more money than if you surrendered the policy.
No need to continue paying premiums.

Cons:

Fees and taxes may apply, reducing the amount you receive.
Your beneficiaries won’t receive the death benefit.

Capital for Life Recommends this is Best For:
Seniors who no longer need the coverage and want to maximise the value of their policy while still alive.

5. Premium Financing

How It Works:
Premium financing allows you to borrow money to pay the premiums on your life insurance policy, using the policy itself as collateral. This strategy is commonly used by high-net-worth individuals for estate planning purposes.

Pros:

You keep the policy in force and retain the death benefit.
May reduce or eliminate your out-of-pocket costs for premiums.

Cons:

If the financed premiums are not repaid, the policy could lapse.
Premium financing is often risky and requires careful financial planning.

Capital for Life Recommends this is Best For:
High-net-worth individuals who want to use the policy for estate planning or investment strategies and have the means to manage the financial risk.

How Long Does It Take to Cash Out a Life Insurance Policy?

The time it takes to cash out a life insurance policy can vary depending on the method you choose. Here’s a breakdown:

Withdrawals and Policy Loans: These are generally the fastest methods, taking anywhere from a few business days to a couple of weeks to process. The exact timing depends on your insurance provider’s processing time.
Surrendering a Policy: Surrendering your policy usually takes longer, often around two to six weeks, because the insurance company will need to process your request and determine the cash surrender value after deducting fees.
Selling a Policy (Life Settlement): Selling your policy can take several months due to the complexity of finding a buyer, conducting necessary paperwork, and waiting for regulatory approval.
Premium Financing: If you are using premium financing to access cash, the process can also take several weeks to arrange, depending on the complexity of the financing deal and the lender involved.

It’s always advisable to check directly with your insurer for specific timelines, as they can vary based on policy type and provider.

Tax Implications and Considerations

Cashing out your life insurance policy can have tax implications, particularly if the cash value exceeds the total premiums you’ve paid. Withdrawals are generally tax-free up to the policy basis (the premiums paid), but any amount beyond that could be taxable as income. Surrendering a policy or selling it (through a life settlement) may also trigger taxes, depending on how much you’ve earned beyond the premiums paid.

If you’re considering cashing out a policy, it’s essential to consult a tax professional to understand the specific implications for your situation. Additionally, cashing out can affect your estate planning, potentially reducing the financial protection you originally intended for your loved ones.

Conclusion

Cashing out a life insurance policy can provide much-needed financial relief, but it’s important to carefully review each policy option and its impact on your long-term financial planning and overall goals. Whether you’re considering a withdrawal, loan, surrender, sale, or premium financing, be sure to consult with a financial advisor or expert life insurance agent to determine the best path for your situation. Making an informed decision ensures you balance both your current needs and your family’s future security.

By understanding the available options, their pros and cons, and the associated tax implications, you can move forward with the decision that best suits your financial circumstances.

Frequently Asked Questions (FAQs)

What are the tax consequences of cashing out a life insurance policy?

When you cash out a life insurance policy, the tax implications depend on how you access the funds:

Withdrawals: If you withdraw money from the cash value, the amount is generally tax-free up to your policy basis, which is the total premiums you’ve paid. However, any amount you withdraw that exceeds this basis may be taxed as ordinary income.
Loans: Borrowing against your policy’s cash value is tax-free as long as the policy remains in force. However, if the policy lapses or is surrendered, the outstanding loan balance could be subject to taxation.
Surrendering: If you surrender the policy, the difference between the cash surrender value and the premiums paid into the policy (your basis) is taxable as ordinary income. Additionally, you might face surrender charges if you terminate the policy early.
Selling the Policy (Life Settlement): When you sell a policy, the proceeds can be taxed. The amount up to the policy basis is tax-free, while any amount beyond that could be taxed as a capital gain or ordinary income, depending on the circumstances.

It’s advisable to consult a tax advisor before cashing out to understand your specific tax liabilities.

Can I access the cash value while keeping my policy in force?

Yes, you can access the cash value of your life insurance policy without canceling it, using one of the following methods:

Partial Withdrawals: You can take out part of the cash value. While this may not cancel the policy, it could reduce the death benefit.
Policy Loans: You can borrow against the policy’s cash value. The loan doesn’t reduce the death benefit unless it is unpaid, but it does accrue interest. If you don’t repay the loan, the outstanding balance will be deducted from the death benefit.

These methods allow you to keep the policy active, but it's important to keep track of how withdrawals or loans affect the overall policy performance and coverage. In some cases, you may need to pay higher premiums to maintain the policy.

Is there a penalty for cashing out early?

Yes, many life insurance policies impose surrender charges if you cash out early, typically during the first 10 to 15 years of the policy. These charges are designed to recoup the insurance company’s costs and can significantly reduce the amount of money you receive. The longer you’ve held the policy, the lower the surrender charges tend to be.

Additionally, if you have a North American life policy and it is classified as a Modified Endowment Contract (MEC), withdrawals or loans may be subject to income tax and a 10% penalty if you’re under 59½.

It’s critical to check your policy terms or speak with your insurer to understand how surrender charges and penalties might apply to your specific situation.

What happens to the death benefit if I cash out?

The effect on the death benefit depends on how you choose to access the cash value:

Withdrawals: These reduce the death benefit dollar-for-dollar, meaning your beneficiaries will receive less upon your passing. In our experience, some insurers will allow you a free withdrawal facility, typically 5% or 10% against the cash value without reducing the death benefit.
Loans: Borrowing against the policy’s cash value does not immediately reduce the death benefit, but the loan balance plus interest will be subtracted from the death benefit if it isn’t repaid upon death.
Surrendering the Policy: When you surrender a policy, the death benefit is eliminated entirely, and your beneficiaries won’t receive anything when you pass away.
Selling the Policy (Life Settlement): Once the policy is sold, the new owner becomes the beneficiary and collects the death benefit, leaving your original beneficiaries with nothing.

Each option impacts the death benefit differently, so it’s essential to evaluate your long-term needs before deciding how to access the cash value.

What are the alternatives to cashing out a policy?

If you need funds but don’t want to cash out your life insurance policy, consider these alternatives:

Personal Loans: You can take out a loan from a bank or lender rather than tapping into your policy. This preserves the death benefit for your beneficiaries.
Policy Adjustments: Speak to your financial adviser or life insurance agent about reducing the premium payments or adjusting the life coverage to make the policy more affordable without needing to cash out.
Using Dividends (For Participating Policies): Some whole life policies pay dividends, which you can use to fund premium payments or receive as cash.
Accelerated Death Benefits: If you’re terminally ill, you may be able to access a portion of the death benefit early to cover medical costs.

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Conclusion

Cashing out a life insurance policy can provide much-needed financial relief, but it’s important to carefully evaluate each option and its impact on your long-term financial goals. Whether you’re considering a withdrawal, loan, surrender, sale, or premium financing, be sure to consult with a financial advisor to determine the best path for your situation. Making an informed decision ensures you balance both your current needs and your family’s future security.

By understanding the available options, their pros and cons, and the associated tax implications, you can confidently move forward with the decision that best suits your financial circumstances.

Disclaimer

This article is authored by Carlton Crabbe, Chief Executive Officer of Capital for Life, a specialist life insurance broker. The information provided in this article is for educational and informational purposes only and should not be construed as financial or investment advice. While the author possesses expertise in the subject matter, readers are advised to consult a qualified financial advisor before making investment decisions or purchasing life insurance products.

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