A “cash-out insurance policy” isn’t an official insurance industry term, but it commonly refers to permanent life insurance policies—like whole life or universal life—that build cash value over time. This cash value component is one of the policy’s most attractive features, as it allows the policyholder to access funds while they are still alive.
However, tapping into this value is a significant financial decision that can affect your death benefit and create unexpected tax liabilities. This in-depth guide will break down what these policies are, how you can “cash out,” and the critical factors to consider before making a choice.
What is Cash Value Life Insurance?
Unlike term life insurance, which provides coverage for a specific period and typically has no cash value, permanent life insurance policies offer lifelong coverage and a tax-deferred savings component called cash value. A portion of each premium payment goes toward this cash value, which grows over time.
Key permanent life insurance types that accumulate cash value include:
- Whole Life Insurance: Premiums are level, and the cash value grows at a guaranteed rate.
- Universal Life Insurance: Offers flexible premiums and a cash value that can grow based on market interest rates.
How Can You Access the Cash Value?
The term “cashing out” can mean a few different things when it comes to a permanent life insurance policy. You generally have three main methods for accessing the cash value:
1. Policy Loans
You can borrow money from the insurance company, using your accumulated cash value as collateral. This is often the most flexible option:
- Pros: Loans are generally tax-free and do not require a credit check. Repayment is often flexible, though interest accrues.
- Cons: Any outstanding loan balance and accrued interest will be deducted from the death benefit paid to your beneficiaries. If the loan balance exceeds the cash value, the policy can lapse, which may result in the outstanding loan being treated as a taxable distribution.
2. Withdrawals
You can take a direct withdrawal from the cash value of your policy. This is a permanent removal of funds.
- Pros: Withdrawals are typically tax-free up to your cost basis (the total amount of premiums you have paid into the policy).
- Cons: The withdrawal will permanently reduce the policy’s death benefit. Any amount withdrawn that is greater than your total premiums paid (the gains) may be considered taxable income.
3. Policy Surrender
Surrendering your policy is the most definitive way to “cash out.” You cancel the coverage entirely in exchange for the cash surrender value.
- Pros: You receive a lump sum of cash. You no longer have to pay premiums.
- Cons: Your life insurance coverage immediately ends, and your beneficiaries will receive no death benefit. The cash surrender value may be reduced by surrender charges, especially if done in the early years. Any gain (the cash value received minus your total premiums paid) will be taxed as ordinary income.
The Tax Implications of Cashing Out
Understanding the tax consequences is perhaps the most crucial part of this decision. Always consult with a qualified tax advisor, but here are the general rules:
| Action | Tax Status | Impact on Death Benefit |
|---|---|---|
| Policy Loan | Generally Tax-Free | Reduced by the outstanding loan balance and interest. |
| Withdrawal (up to Basis) | Generally Tax-Free | Permanently reduced by the amount withdrawn. |
| Withdrawal (of Gains) | Taxable as Ordinary Income | Permanently reduced by the amount withdrawn. |
| Policy Surrender | Gains (Value minus Premiums) are Taxable | Terminated (no death benefit). |
Key Note: The “cost basis” is the total amount you have paid in premiums. You are typically only taxed on the portion of the cash-out that represents the investment gains.
Is a Cash-Out Insurance Policy Right for Your Financial Strategy?
Accessing the cash value of your policy can be a smart move, but only if it aligns with your overall financial picture. Ask yourself these critical questions:
Do you still need the death benefit?
If you have dependents (a spouse, children, or elderly parents) who rely on you for financial support, surrendering the policy is likely a poor choice. The death benefit is designed to replace your income and cover final expenses.
Are you in the early years of the policy?
Permanent policies often have high surrender charges in the first 10 to 15 years, significantly reducing the amount you would receive from a full surrender. The cash value also grows slower in the initial years.
Do you have other, less costly borrowing options?
While a policy loan is flexible, it still accrues interest and reduces your death benefit. Compare the interest rate on a policy loan to a home equity loan, a low-interest personal loan, or other available credit options.
What is your financial goal for the funds?
Cashing out may be considered for major life events or financial needs:
- Supplementing retirement income.
- Covering an unexpected emergency expense.
- Paying for a child’s college tuition.
- Funding a business opportunity.
Conclusion: Proceed with Caution and Expertise
A life insurance policy that allows you to “cash out” is a valuable asset, but it comes with complexities. Before you make any decision to take a loan, withdrawal, or full surrender, you must weigh the immediate financial benefit against the long-term cost of reducing or eliminating a crucial piece of financial security for your loved ones. Always speak with your insurance agent and a tax advisor to fully understand the consequences for your specific policy.
Would you like to explore alternative life insurance options that focus purely on a death benefit, like term life insurance, to compare costs?
