During challenging financial periods, individuals often find themselves in need of quick funds to cover their day-to-day expenses and fulfill their lifestyle requirements. One possible solution is to cash in a life insurance policy, but it is crucial to consider whether this is the right decision.
It’s important to recognize that relying on life insurance to address immediate financial needs can have its drawbacks, particularly if it jeopardizes your long-term objectives or the financial stability of your family. However, if alternative options are unavailable, accessing the cash value of a life insurance policy can serve as a viable source of income.
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How You Can Access Cash
Cash-value life insurance, including whole life and universal life policies, allows for the accumulation of reserves through surplus premiums and earnings. These reserves are held in a dedicated cash-accumulation account within the policy. The advantage of cash-value life insurance is that it provides various options to access the accumulated cash, such as withdrawals, policy loans, partial surrender, or complete surrender. Another alternative is to sell your policy through a life settlement for immediate cash.
It’s important to keep in mind that while accessing the cash from your policy can be beneficial during financially challenging times, the method you choose to access the funds may have unintended consequences.
How to Withdrawal From a Life Insurance Policy
In general, it is possible to withdraw a limited amount of cash from a life insurance policy. The availability of funds depends on the type of policy you hold and the issuing company. Cash-value withdrawals offer a significant advantage as they are typically not taxable up to the policy basis, unless the policy is classified as a modified endowment contract (MEC). A MEC refers to a life insurance policy where the funding exceeds the limits set by federal tax laws.
However, it’s important to be aware of the potential consequences associated with cash-value withdrawals:
1. Reduction in Death Benefit: Withdrawing cash from your policy can diminish the cash value, which in turn may result in a decrease in the death benefit. This could impact the funds your beneficiaries might need for purposes like income replacement, business needs, or wealth preservation.
2. Tax Implications: Cash-value withdrawals are not always tax-free. If you make a withdrawal within the first 15 years of the policy, and it leads to a reduction in the death benefit, a portion or all of the withdrawn cash might be subject to taxation. Withdrawals exceeding your policy basis are treated as taxable income.
3. Premium Increases: When you reduce the cash surrender value through withdrawals, your premiums may increase to maintain the same level of death benefit. Otherwise, there is a risk of policy lapse.
4. MEC Classification: If your policy is classified as a MEC, withdrawals are generally subject to taxation according to the rules applicable to annuities. Cash disbursements are considered to be sourced from interest first and may be subject to income tax. If you’re under the age of 59½ at the time of withdrawal, there could also be a 10% early-withdrawal penalty.
It’s important to carefully consider these factors before making cash-value withdrawals from your life insurance policy. Consulting with a financial professional can provide further guidance based on your specific situation.
Taking a Loan From Your Life Insurance
Many cash-value life insurance policies offer the option to borrow money from the insurer by using the cash-accumulation account as collateral. Qualifying for the loan is typically not dependent on your financial situation, although the loan may accrue interest at varying rates based on the policy terms. The amount you can borrow is determined by the value of the cash-accumulation account and the terms of the contract.
The positive aspect is that loans from non-MEC policies are generally not taxable, and you are not required to make regular loan payments, although the outstanding balance may accumulate interest.
On the downside, loan balances typically reduce the death benefit of your policy, meaning that your beneficiaries may receive less than originally intended. Additionally, an unpaid loan with accruing interest can diminish your cash value, potentially causing the policy to lapse if insufficient premiums are paid to maintain the death benefit. If the policy lapses or if you surrender the insurance with an outstanding loan, the borrowed amount becomes taxable to the extent that the cash value exceeds your basis in the contract, without considering the outstanding loan balance.
In the case of a policy classified as a MEC, policy loans are treated as distributions. This means that the loan amount, up to the policy’s earnings, may be subject to taxation and could also incur the pre-59½ early-withdrawal penalty.
Please note that withdrawing or borrowing money from your life insurance policy has the potential to decrease the death benefit provided by the policy. On the other hand, surrendering the policy means forfeiting the right to the death benefit entirely.
Surrendering a Policy
Aside from withdrawals and policy loans, another option is to surrender (cancel) your life insurance policy and utilize the cash as desired. However, it’s important to note that surrendering the policy in the early years of ownership typically incurs surrender fees imposed by the company, which can reduce the cash value. The specific charges vary based on the duration of your policy ownership.
Moreover, when you surrender the policy for cash, the gain on the policy becomes subject to income tax. Additional taxes may apply if you have an outstanding loan balance against the policy.
While surrendering the policy can provide the immediate cash you need, it also means giving up the death benefit protection provided by the insurance. If you intend to replace the lost death benefit in the future, obtaining equivalent coverage might be more challenging or costly.
NOTE: According to Investopedia, it is recommended to explore alternative options before resorting to cashing in your life insurance policy, especially if you have the means to do so. Consider options like borrowing against your 401(k) plan or obtaining a home equity loan. It’s important to note that each of these alternatives has its own considerations and potential drawbacks. However, based on your current financial circumstances, certain choices may be more favorable than others.
The process of cashing in a life insurance policy through a life settlement is relatively straightforward. You sell your policy to an individual or a life settlement company in exchange for cash. The new owner takes over the policy, paying the premiums and ultimately receiving the death benefit upon your passing.
Life settlements are available for various types of insurance, including those with minimal or no cash value, such as term insurance. Generally, to qualify for a life settlement, you, as the insured, should be at least 65 years old, have a life expectancy of 10 to 15 years or less, and possess a policy death benefit of at least $100,000 in most cases.
The primary advantage of a life settlement is that it typically yields a higher payout compared to simply cashing in (surrendering) the policy. However, the taxation of life settlements can be complex. Typically, any gain exceeding your policy’s basis is treated as ordinary income and subject to taxation. It is crucial to seek expert tax advice before proceeding with the transfer of your policy.
While life settlements can provide valuable liquidity, it’s important to consider the following factors:
1. Loss of Control: By selling your policy, you relinquish control over the death benefit.
2. Access to Medical Records: The new policy owner(s) may have access to your past medical records and may request updates on your current health status.
3. Lack of Regulation: The life settlement industry is minimally regulated, making it challenging to determine the fair value of your policy.
4. Costs and Commissions: Life settlements often incur significant commissions and fees, which can amount to as much as 30% of your proceeds. This reduces the net amount you receive.
Considering these factors, it is advisable to carefully weigh the pros and cons and seek professional guidance when considering a life settlement as a cash option for your life insurance policy.
Can You Cash Out a Life Insurance Policy?
Certainly! It is possible to cash in a life insurance policy and receive a payout based on the accumulated cash value within the policy. The amount of money you receive will depend on the cash value held in the policy. For instance, if you have $10,000 of accumulated cash value, you would have the option to withdraw the entire amount, subject to any applicable surrender fees.
However, it’s important to note that cashing in the policy would result in its termination. Alternatively, you can choose to withdraw smaller amounts or take a policy loan against a portion of the cash value, often up to 90% of the total amount.
Do You Have to Pay Taxes When Cashing out a Life Insurance Policy?
When you cash in a life insurance policy, the taxation of the proceeds depends on the specific amount you withdraw. If you withdraw up to the total premiums paid into the policy, it is generally not taxable since it is regarded as a return of premiums. However, if you go on to withdraw any earnings or gains from the policy, such as dividends, those amounts may be subject to taxation as ordinary income.
Is There a Penalty for Cashing out Life Insurance?
When cashing out a complete life insurance policy, it’s important to be aware of any potential surrender fees. These fees may apply and are typically in the range of 10% to 20%, although they can sometimes be as high as 35% to 40%. To get precise information about your specific policy, refer to your policy contract and review the details regarding surrender fees. Apart from the surrender fee, there are typically no additional penalties or fees associated with cashing in a life insurance policy.
How Much Will I Receive If I Surrender My Life Insurance Policy?
When you choose to surrender your life insurance policy, it’s important to understand that you will not receive the death benefit. Instead, you will receive the cash surrender value of the policy, after deducting any fees imposed by your insurance company. Typically, payments for withdrawals or loans from a life insurance policy, excluding the applicable fees, are processed within 14 to 60 days from the date the request is received.
When Should I Cash Out my Whole Life Insurance?
While it may not be the best course of action to cash in your life insurance policy, experts often suggest waiting for a period of 10 to 15 years to allow your cash value to increase. Before making any decisions, it is advisable to seek guidance from your insurance agent or a retirement specialist, particularly when considering cashing in a whole life insurance policy.
During challenging economic times, it’s natural to consider selling assets to obtain cash. However, when it comes to your life insurance policy, it’s crucial to reflect on the reasons behind your initial purchase. Do you still require the coverage it provides? Are your beneficiaries relying on the policy’s death benefit in the event of an unfortunate incident? Take the time to carefully consider the answers to these questions.
Before cashing in your life insurance policy, it is prudent to explore alternative options. Investigating possibilities like a home equity loan, borrowing from your retirement account, or even utilizing provisions within your insurance policy, if permitted, can be worthwhile. By doing so, you may avoid prematurely surrendering a life insurance policy that you might find necessary or valuable in the future.