2 Times Cashing Out a Whole Life Policy Makes Sense

Love it or hate it, whole life insurance is an interesting financial product.

Whole life insurance is an interesting product. Unlike term life insurance, a whole life policy can last your entire life, as long as you continue to make the payments. And that's the rub. A whole life policy can cost five to 15 times as much as term life. At some point, whole life policyholders may grow tired of making the payments, even if their policy builds cash value over the years.

Here are two times whole life policyholders may consider cashing out.

1. Premium payments are out of reach

If you have a whole life policy, you know that the payments are higher than you would pay for a term life policy with the same death benefit (or more). However, a term life policy does not accrue cash value and is only active for a specific number of years.

Let's say that your budget is stretched to its limit and you can no longer afford to make the payments on your whole life policy. You know that if you miss payments, the policy will be canceled and you'll lose any money you've paid toward it.

You have a couple of options to consider.

Cash out

If you have cash built up in the policy, you can cash it out, cancel the policy, and purchase a term life policy with the same death benefit. If you're still relatively young and healthy, a term life policy should be less expensive. If you're older, though, you could pay just as much for a term policy purchased today as you're paying for a whole life policy purchased years ago. A new policy is not always less expensive.

Ask about a 1035 exchange

Contact your insurance agent and let them know that you're having trouble making payments. You may be able to exchange your current policy for another, more affordable, insurance policy. This is called a 1035 exchange, and it's tax free.

With a 1035 exchange, you may even be able to use the cash value in your existing policy to buy a new type of policy or insurance riders that are not included on your original policy.

The tricky bit here is that you don't want to move from one expensive policy to another. Make it clear to your agent that you need a less expensive plan.

Note: If you have beneficiaries who count on your income, canceling your policy without another life insurance policy in place is a dangerous financial move. Even if it means cutting back on other expenses or taking on a side hustle, few things are more important than a life insurance policy for the average family.

2. You no longer need the death benefit

Not everyone needs life insurance. If you're getting older and have no beneficiaries to look out for, you may wonder why you're still making whole life payments. You also have a couple of options.

Cash out

Cash out, cancel the policy, and invest the funds received.

Switch to a policy you do need

If you don't currently carry long-term care insurance, ask your agent about using a 1035 exchange to switch from whole life to a policy with long-term care coverage.

Financial considerations

The catch associated with cashing out a whole life policy is that it will cost you. Here are two expenses the average policyholder can expect to face.

Surrender fees

Surrender fees vary by insurance company. Typically, the fee is a percentage of the cash value of the policy. The longer you've held the policy, the lower the surrender fee. That's because surrender fees drop over time.

Federal income taxes

Any cash value you receive may be taxable as income. Let's say you're in the 24% tax bracket and have $20,000 in cash value. That means that you're likely to owe $4,800 in income taxes.

Ask questions

The decision to surrender a policy is a serious one. If you don't have another policy firmly in place it could cost those you leave behind -- big.

Before you do anything, ask your insurance agent about other options. For example, if the reason you can't make payments is because you're chronically ill, you may be able to take cash out of the policy to help pay living expenses. If you're terminally ill, you can also apply for "living benefits."

The point is, your insurance agent is your best point of contact when it's time to discuss options that will work for both you and those you care about.