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There may come a time when you no longer want or need your cash value life insurance policy.
Before you cash out your policy, consider your options and decide whether surrendering your policy is the best choice for you.
It is important to note that there are alternatives to a cash value surrender, including options that pay more.
This article details how a cash value surrender works and outlines other solutions that may be available to you.
Reasons to Surrender Your Policy
When you surrender your life insurance, you are telling the insurance company that you don’t want life insurance coverage. In exchange, the policyholder receives a portion of the cash value of the policy.
If you own a term or cash value life insurance policy that you no longer need, you may be wondering if it’s worth continuing to pay the premiums. If the answer is no, you have to decide what to do with the policy. You have several alternatives to choose from, but the simplest way is to surrender the policy altogether.
Here are the most common reasons why people surrender their life insurance policies.
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. Of course, your divorce decree may stipulate that you keep the policy in force with your ex as a beneficiary.
Another common scenario is naming your children as beneficiaries, but they no longer need the coverage as adults. This often happens when the adult beneficiaries are financially stable and have no need for financial assistance.
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. This amount will generally be 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.
If you are surrendering your policy just to access the cash value, consider a life settlement instead.
Less Expensive Coverage is Available
Has your health substantially improved since you took out your last policy (e.g., your weight changed dramatically or you quit smoking)? Then it may be wise to surrender your current policy and take out new coverage.
However, you may come out ahead by instead exchanging your current policy into the new one via a tax-free 1035 exchange.
Miscellaneous reasons might include:
- Your current policy no longer meets your needs.
- Better performing policies are now available.
- Premiums have become too expensive.
How to Surrender Your Policy
Surrendering your life insurance policy is a relatively simple process.
If you want to cancel your coverage:
- Stop paying the premiums
- Contact the insurance company and tell them that you want to cancel the policy.
- You will need to ask the insurance company to send you a surrender form or have them tell you where you can download one online.
- Also, ask them whether a letter of instruction will suffice to cancel the policy.
- Complete the form (or letter of instruction) and send it to the insurance company via certified or overnight mail for tracking purposes.
- Once the tracking system shows that it was received, call the company to confirm that they received your request. They will then cancel the policy, and you won’t owe them anything more.
This process is the same for both permanent life insurance (such as whole life and universal life) and term life insurance.
Understanding Cash Surrender Value
If you are canceling something other than a term policy, you will probably have a small amount of money left after cancellation. The life insurance company will calculate this value, known as the cash surrender value or the non-forfeiture 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.
The insurance company can only hold your cash surrender value for a set period that is determined by law before they have to give it to you.
Many life insurance companies offer policies that have surrender periods that last for 10 to 15 years. Surrender charges can be substantial during the first few years of the policy. Because of this, it is generally not advantageous to cancel a new policy.
Tax Rules for Surrendering a Life Insurance Policy
The taxation of a surrendered cash value life insurance policy is very simple.
Any amount that you receive over the total amount of premiums you paid (known as the cost basis) is taxed as ordinary income. This means that you will pay tax on this amount at your top marginal tax rate.
For example, say that you are in the 25% tax bracket and you paid a total of $10,000 of premiums into your cash value (universal life insurance) policy.
Your cash value is now worth $13,000, and you decide to surrender your policy. You pay $1,000 in surrender charges and receive a check from the insurance company for $12,000. You will pay tax on $2,000 at a rate of 25%.
The other $10,000 is considered a tax-free return of principal.
Alternatives to Surrender
There are several ways that you can access the cash value in your life insurance policy that don’t require you to surrender it. Here are some alternatives to choose from:
In a 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.
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 charged to the cash value in the policy but the interest rate is usually less than you would pay other traditional lenders.
This is great for those with poor credit histories because there are no underwriting requirements of any kind for this type of loan. You are essentially borrowing your own money out of the policy.
The most profitable way to cancel your coverage is with a life settlement.
In a life settlement, 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 up front at the time of purchase.
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The chief advantage is that you generally receive much more than the amount of cash value that has accumulated in the policy.
The Tax Cuts and Jobs Act of 2017 made the tax rules for this type of transaction much simpler.
There are now basically three ways that the amount you receive is taxed:
- All money that you are paid up to the total amount of premiums that you paid is considered a tax-free return of principal.
- All money that is paid in excess of this amount is taxed as ordinary income at your top marginal tax rate.
- All money received over the policy’s cash value is taxed as a long-term capital gain.
Be aware that these alternatives are only available for cash value policies such as universal life policies. These options are not available for term life insurance policies.
This process is materially identical to the life settlement process, but you will generally receive a higher payout using this alternative. The tax rules are also the same.