There can come a time when that cash value life insurance policy that you bought years ago becomes superfluous to your current financial situation. Perhaps you’d want to look into surrendering your life insurance policy.
Reasons You May Want to Surrender Your Policy
When you surrender life insurance, you are essentially cashing in the policy and telling the insurance company that you don’t want or need the coverage anymore. If you own a term or cash value life insurance policy that you no longer need, then you may be wondering if it’s worth continuing to pay premiums for it. In many cases, the answer may be no, and then you’re left with the question of what to do with the policy. You have several alternatives to choose from, but the simplest way is to simply surrender the policy altogether. Here are some reasons why you may want to surrender your policy:
- The coverage is no longer needed – There are several reasons why you may choose to surrender your life insurance policy. If your policy’s beneficiary predeceases you, or you named your spouse as your beneficiary and are now getting a divorce, then you no longer need that coverage. (Of course, your divorce decree may stipulate that you keep the policy in force with your ex as beneficiary.) Or, if you named your children as beneficiaries, they may no longer need the coverage once they’re grown. And a key man life policy may become obsolete if the company changes ownership.
- 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. But this can be a valuable source of quick cash for someone who doesn’t have access to other liquid assets and needs cash now.
- When less expensive coverage is available – If your health has substantially improved since you took out your last policy, such as if you have lost a large amount of weight or quit smoking, then you may be wise to surrender your current policy and take out new coverage. (But instead of just surrendering your policy, you may come out ahead by simply exchanging your current policy into the new one via 1035 exchange).
- Miscellaneous reasons – These include if your current policy no longer meets your needs, there are better performing policies now available or the premiums have just 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, then you can just 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 just 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 write the LOI) and send it to the insurance company via certified or overnight mail so that it can be tracked. Call the company to confirm that they received your request once the tracking system shows that they got it. They will 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.
Cash Surrender Value
Unless you are cancelling a term policy, you will most likely have at least a small amount of money left over after the policy has been cancelled that you can use for any purpose you desire. The life insurance company will calculate this value, known as the cash surrender value or the non-forfeiture value.
The calculation is based on the total amount of premium payments that you have made into the policy, the performance of the investments that the cash value is held in and any applicable surrender fees. The cash surrender value is therefore the amount of money that you will receive after any and all surrender charges and administrative costs have been subtracted from the policy’s cash value and any outstanding loans have been repaid.
Many life insurance companies offer policies that have surrender periods that last for 10 to 15 years, and these charges can be substantial during the first few years of the policy. Therefore it is generally not advantageous to cancel a new policy. But the insurance company can only hold your cash surrender value for a set period of time that is determined by law before they have to give it to you.
The taxation of a cash value life insurance policy that is surrendered is very simple. Any amount that you receive in excess of the total amount of premiums that you paid (known as the cost basis) is taxed as ordinary income, which 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.
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:
- Direct withdrawal – You can simply take money out of your cash value but leave enough in the policy to keep it in force. You will have to continue paying premiums, but you can keep the death benefit protection this way. The death benefit will be reduced by the amount you withdraw.
- Policy loan – 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 that is charged is usually less that you would pay to a bank or other traditional lender. This method is especially advantageous for those with poor credit histories, because there are no underwriting requirements of any kind for this type of loan. This is because you are essentially borrowing your own money out of the policy.
- Life settlement – If you want to cancel your coverage, the most profitable way to do it is with a life settlement, where 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. The chief advantage to this alternative is that you will 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, and all money received in excess of the policy’s cash value is taxed as a long-term capital gain. It should be noted 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.
- Viatical settlement – If you are terminally ill or are unable to perform at least two of the six activities of daily living (ADL), then you can sell your policy in a viatical settlement. 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.
Consequences of Surrender
When you surrender your policy, remember that you are forfeiting the death benefit that was earmarked for your beneficiaries, so you need to think twice about taking this route, especially if you are doing it just to get the cash value. A life or viatical settlement will usually get you the most bang for your buck, but a policy loan is also usually a better option. Consult your financial advisor or life insurance agent for more information on how you can access the cash value in your policy or surrender it.