When financial hardships occur, you may be left with few alternatives that you can use to meet unexpected expenses.
Cash value life insurance policies can provide you with money at a time when you need it.
These policies contain built-in savings accounts that accumulate cash value over time from the premiums that you pay.
However, there are a few different alternatives to choose from when it comes to cashing in your life insurance policy.
Knowing the pros and cons of each option will enable you to make the best choice possible to fit your needs.
How Can You Cash Out a Life Insurance Policy? (4 Options):
Cash Value Withdrawal
The most direct way to access the cash value in your policy is to make a withdrawal from it. You can do this by notifying your life insurance carrier that you would like to take money out of your policy. The carrier will process your claim and send you a check.
The amount that you can withdraw will vary according to the type of policy that you have as well as the insurance carrier that you use.
Things to Consider With Cash Value Withdrawals
It is important to understand a couple of key disadvantages that come with this alternative.
First, withdrawing money from the cash value may increase your premium payments, thus making the policy more expensive. And if you can’t afford the new higher premiums, then the policy could lapse.
It can also reduce the death benefit that your beneficiaries will receive, thus depriving them of money that they may be counting on. So be sure to find out from your life insurance carrier what the impact will be on your policy if you make a withdrawal.
If your life insurance policy has been classified as a MEC (Modified Endowment Contract), then your withdrawals will be subject to taxation. MECs are taxed in the same manner as annuities, and all initial withdrawals from them are considered to be taxable interest until you have withdrawn enough money to start dipping into your principal.
You will also pay a 10% early withdrawal penalty on any money you take out of a MEC if you are under age 59 ½. But withdrawals from a cash value policy are always tax-free as long as you withdraw less than the total of all of your premium payments.
If your cash value has grown to the point where it is larger than all of your premium payments, then the amount of premium withdrawn that exceeds your total premium payments will be taxed as ordinary income.
Taking a cash withdrawal can ultimately be a good idea, despite the potential disadvantages. If you need to find out whether your policy is a MEC, this page will tell you which type of policy you have.
Taking Out a Loan With Cash Value as Collateral
Another way to access the cash value in your policy is to take out a loan using the cash value as collateral. This method is convenient for those with poor credit records, as there are no financial or underwriting requirements for policy owners who wish to borrow from their policies.
Another advantage is that the loan does not have to be repaid; the policy will simply have less cash value from then on. However, the insurance company will usually charge interest on the loan amount, which you will either have to pay in cash or from the remaining cash value in the policy.
Like withdrawals, the amount of money that you can borrow from your policy will depend upon the loan provisions of the policy along with the loan parameters set by the insurer.
Things to Consider When Using Life Insurance as Collateral
As mentioned previously, one of the main drawbacks to taking out a loan is the interest that is charged by the insurer on the outstanding loan balance.
Although you don’t have to repay the loan, if you take out a large loan from your policy, then you may run the risk of having your policy lapse due to the interest payments. And any outstanding balance from a loan will be deducted from the death benefit paid to your beneficiaries upon your death.
All loan proceeds are tax-free, regardless of what type of cash value policy you own. But if the policy lapses or you surrender it, then any loan proceeds that have not been repaid will be counted as taxable income to the extent that it exceeds your total premium payments into the policy.
If your policy is a MEC, then loans are classified as normal taxable distributions, with an additional 10% penalty if you take out a loan before you reach age 59 ½.
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Surrendering Your Policy
Surrendering your policy is another option. In this case, you inform the insurance carrier that you want to cancel your policy, and they will send you a check for the amount of cash value that accumulated while the policy was in force.
Things to Consider with Surrendering Your Life Insurance Policy
Any money received that exceeds your cost basis in the policy will be counted as ordinary taxable income. And, of course, cashing in your policy will prevent your heirs from receiving any death benefits, so you need to carefully consider the possible impact on your beneficiaries. You may also pay taxes on any outstanding policy loans at the time of surrender.
Another factor to consider is that if you surrender your policy within just a few years of taking it out, then the carrier may assess you with a stiff surrender charge penalty that will reduce the surrender value of your policy.
Finally, it may be more difficult for you to get replacement coverage in the future, especially if your health has declined. You may have to look at a term policy instead of one with cash value to get death benefit coverage at a reasonable cost.
If you have term life insurance, you may be allowed to contact your life insurance carrier and convert your term coverage into a lesser amount of paid-up coverage. Then you can access the cash value in the policy using one of the methods listed here. But again, you will effectively forfeit your death benefit from your term policy, which can have a significant impact on your estate plan.
Selling Your Life Insurance Policy
The final method you can use to access the cash value is to sell your life insurance policy. The life settlement industry has matured a great deal in recent years, so it’s not hard to find a willing buyer in this arena.
You may also be able to find a friend or relative who needs coverage and would be willing to buy your policy.
However, it is possible to sell a policy with little or no cash value. Once you have sold your policy, the buyer will assume responsibility for premium payments and his or her (or their) beneficiaries will receive the death benefit.
The key benefit for the seller of a life insurance policy is that this form of transfer usually puts more money in the pocket of the seller than they would get by simply surrendering the policy.
The amount that you walk away from could easily be two or three times the actual cash value. However, the taxation of this type of sale can be complex in many instances. The general rule of thumb is that any amount that you receive in excess of the cost basis of the policy (the total amount of premiums that you paid) will be taxed as ordinary income. But it would be wise to consult with your tax advisor before selling your policy, as there can be many minute issues that can impact your taxes for that year.
Things to Consider With Selling Your Life Insurance Policy
Some of the disadvantages that come with selling your policy are that you are giving up control of the death benefit. Your heirs will no longer receive this when you die, even though you are still the insured on the policy.
The new owners may also require you to furnish all of your medical records, and then keep them abreast of any new developments with your health.
Perhaps the biggest disadvantage to selling your policy is the high fees and expenses that are charged to you upon the sale. You might have to forfeit a third of the sale price to pay all of the fees, expenses, and commissions.
It can also be difficult to ascertain a fair value for your policy, so much of your return on this transaction may boil down to your negotiating skills. Although the life settlement industry has become considerably less risky and more liquid in recent years, this industry is still in its infancy, and is governed by a relatively small list of regulations. Look for more laws and rules to appear in this sector in the future.
It is probably wise for you to shop around a little and get several quotes from life settlement companies to get an idea of how valuable your policy is.
What are the Best Ways to Cash Out a Life Insurance Policy?
- Leverage cash value withdrawals
- Use life insurance as loan collateral
- Surrender your life insurance policy
- Sell your life insurance policy
These alternatives apply to any type of permanent life insurance, whether you have a whole life insurance policy, universal life insurance or variable universal life policy.
The best choice for you will depend on your investment objectives and circumstances. In some cases, it may make more sense for you to borrow from your 401(k) plan or take out a home equity loan than to access the cash surrender value in your policy.
It is always wise to think twice when it comes to canceling any type of insurance coverage. But if you have a policy that you no longer need, then cashing it in or selling it may be the best option. Consult your financial advisor for more information.