When and how to do it
During difficult economic times, people may find themselves struggling for cash to fulfill their daily needs and lifestyle expectations. Sure, you may cash in your life insurance policy to get the money you need, but should you?
There are obviously disadvantages to purchasing life insurance to fulfill immediate monetary demands, especially if you are jeopardizing your long-term ambitions or the financial future of your family. Nonetheless, if no other choices are available, life insurance, particularly cash-value life insurance, can provide a source of much-needed income.
Key Takeaways
- If you are out of choices and need to access your life insurance policy, it is preferable to withdraw or borrow funds rather than surrendering the policy entirely.
- Excess premium payments and profits are retained in a cash accumulation account under a cash-value life insurance policy, such as whole life or universal life.
- Such accounts enable policyholders to access their money through withdrawals, policy loans, or, if necessary, relinquishing the account in part or in full.
- Another alternative is to make a life settlement, which means selling your life insurance policy to a person or a life settlement firm for cash.
How You Can Access Cash
Excess premiums plus revenues are used to develop reserves in cash-value life insurance, such as whole life and universal life. These deposits are maintained in the policy’s cash-accumulation account.
Cash-value life insurance allows policyholders to access cash accumulations through withdrawals, policy loans, or partial or complete surrender of the policy. Another option is to sell your insurance for cash, a process called a life settlement.
Keep in mind that, while cash from the insurance may be valuable during difficult financial circumstances, you may suffer unfavorable repercussions depending on how you utilize the benefits.
Cashing In Your Life Insurance
Withdrawals
In general, a life insurance policy can be withdrawn for a restricted amount of cash. The amount available varies depending on the type of policy you possess and the business that issued it. The key advantage of cash-value withdrawals is that they are not taxed up to your policy base, as long as your policy is not categorized as a modified endowment contract (MEC). A MEC is a word used to describe a life insurance policy whose funding exceeds the federal tax law restrictions.
Cash-value withdrawals, on the other hand, might have unanticipated or unanticipated consequences:
- Withdrawals that diminish your cash value may result in a reduction in your death benefit, which might be a source of funds for your dependents to utilize for income replacement, business objectives, or wealth preservation.
- Withdrawals of cash value are not usually tax-free. If you take a withdrawal during the first 15 years of the policy, for example, and the withdrawal reduces the policy’s death benefit, some or all of the withdrawn funds may be liable to taxes.
- Withdrawals are taxed to the extent that they exceed your policy basis.
- Withdrawals that diminish your cash surrender value may cause your premiums to rise in order to retain the same death benefit; otherwise, the policy may lapse.
- If your policy has been classified as a MEC, withdrawals are generally taxed according to annuity rules – cash disbursements are considered to be made from interest first and are subject to income tax and possibly a 10% early-withdrawal penalty if you are under the age of 59½ at the time of the withdrawal.
Loans
The majority of cash-value insurance allows you to borrow money from the issuer while using your cash-accumulation account as security. The loan may be subject to interest at varied rates depending on the conditions of the policy; nevertheless, you are not required to financially qualify for the loan. The amount you can borrow is determined by the value of the policy’s cash-accumulation account and the conditions of the contract.
The good news is that borrowed sums from non-MEC plans are not taxable, and you are not required to make loan payments, even if the outstanding loan balance is collecting interest.
The bad news is that loan amounts often diminish the death benefit of your policy, which means your beneficiaries may get less than you expected. Furthermore, an unpaid loan with interest diminishes your cash value, which might cause the policy to expire if insufficient premiums are paid to retain the death benefit. If the loan is still due when the policy expires or if you subsequently surrender the insurance, the borrowed amount becomes taxable to the extent that the cash value (after deducting the existing loan balance) exceeds your contract basis.
Policy loans from a MEC policy are handled as distributions, which means that the amount of the loan up to the profits in the policy is taxable and may be subject to the pre-5912 early-withdrawal penalty.
Withdrawing or borrowing money from your life insurance policy might diminish the death benefit, but surrendering the policy means you give up your claim to the death benefit entirely.
Surrendering a Policy
You can surrender (cancel) your policy and utilize the cash in any way you see appropriate, in addition to withdrawals and policy loans. However, if you surrender the policy during the first few years of ownership, the business would almost certainly charge surrender costs, lowering your cash value. These fees vary according to the length of time you’ve held the insurance. Furthermore, when you surrender your insurance for cash, the gain on the policy is subject to income tax, and if you have an outstanding loan balance on the policy, you may be liable to further taxes.
Although surrendering the policy may provide you with the funds you want, you are definitely waiving your entitlement to the insurance’s death-benefit protection. If you want to replace the lost death benefit later, getting the same coverage may be more difficult or expensive.
Consider alternative possibilities before utilizing your life insurance policy for cash, such as borrowing against your 401(k) plan or taking out a home equity loan; none of these options are without drawbacks, but depending on your present financial situation, some are better than others.
Life Settlement
This is a straightforward notion. As the policy owner, you sell your life insurance policy for cash to a person or a life settlement firm. The new owner will maintain the policy in force (by paying the premiums) and profit from it when you die by getting the death benefit.
Most forms of insurance, even plans with little or no monetary value, such as term insurance, are available for purchase. In general, you (the insured) must be at least 65 years old, have a life expectancy of 10 to 15 years or fewer, and have a policy death benefit of at least $100,000 to qualify for a life settlement (in most cases).
The key benefit of a life settlement is that you may be able to collect more money for your insurance than if you cash it in (surrendering the policy). Life settlements are taxed in a convoluted manner: The usual rule is that any gain over your policy’s base is taxed as regular income. Before you sign over your coverage, seek professional tax counsel.
Although life settlements can be an excellent source of cash, keep the following points in mind:
- You’re relinquishing control of the death benefit.
- The new policyholder(s) will have access to your previous medical information and, in most cases, the right to seek updates on your current health.
- Because the life settlement sector is very little regulated, there is no advice as to the value of your policy, making it difficult to establish if you are receiving a fair price for your policy.
- Aside from the potential tax liability, life settlements frequently come with an additional cost: Commissions and fees might account for up to 30% of your income, reducing the net amount you receive.
The Bottom Line
You may consider liquidating assets for cash if you are experiencing financial difficulties. Sometimes you don’t have a choice, but when it comes to life insurance, consider why you bought the policy in the first place. Do you still require insurance? Are the beneficiaries of the policy reliant on the death benefit if you die? Take time to think about the responses to these questions.