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If finances are tight, you may wonder whether you can cash out a life insurance policy. The answer depends upon the type of policy you hold. The decision to cash out life insurance is not one to take lightly. By the time you finish this article, you'll know which type of policies have cash value, when it makes sense to cash in life insurance while you're still alive, and when you should find another solution to financial trouble.
Yes, it is possible to cash out life insurance, but only with a permanent life insurance policy. To understand which policies allow a person to cash out a life insurance policy, it helps to understand the difference between two key types of life insurance:
There is no cash value associated with a term life insurance policy, but there may be with a permanent life policy. If the insurance policy in question is a permanent policy that accumulates cash, it is possible to cash out a life insurance policy. If this seems a little confusing, stick with us. We'll break it down further.
Keep in mind: It is not possible to cash out life insurance for the full amount of the death benefit. For example, if a person has a permanent life insurance policy with a death benefit of $200,000, they can't cash out the entire $200,000. Unless there are special circumstances (which we'll cover later in this article), they can only cash out a life insurance policy for the cash that has accumulated over the years.
As we mentioned, if someone hopes to cash out a term life policy, they're out of luck. However, with a permanent policy -- like whole life or universal life -- there may be cash from which to draw. Here are five ways to cash in a life insurance policy.
Depending on how much a policyholder pays in premiums, it could take years to build up enough cash from which to draw. However, if someone has been paying for a few years and has a nice pool of cash, they can make a partial withdrawal from cash value life insurance. Say a person has $50,000 in cash value accrued in their account, and they need $25,000. If they were to call their insurance company and ask, "Can I withdraw money from my life insurance?" the answer would almost certainly be yes.
At this point, several things would happen:
It may be possible to take a loan from a life insurance policy. Typically, the policyholder does not have to pay taxes on the amount borrowed -- but they do have to pay interest, just as if they borrowed the money from an outside lender.
A life insurance loan is not like a traditional bank loan. For one thing, the policyholder does not have to repay the loan. The sticky bit here is that they are responsible for making interest payments whether or not they repay the amount borrowed. If they fail to make interest payments, those payments are withdrawn from the cash value remaining in the policy. Once the cash value is depleted, the insurance company is likely to cancel the life insurance policy for non-payment.
If a policyholder takes cash out of a life insurance policy through a loan and pays it back entirely, their beneficiaries will receive the full death benefit upon the policyholder's death. If they die while there is a balance owed, that amount (plus interest) is subtracted from the death benefit paid to beneficiaries.
Let's say a person has paid on a permanent life insurance policy for 30 years. They purchased the policy because they owned a business and did not want to leave their business partner in the lurch if they died. Now they've sold the business, have plenty of money in the bank, and don't want to pay for a policy they don't need. They decide to take the cash surrender value of the insurance policy.
In return for withdrawing the entirety of cash value, they must surrender the policy to the insurance company. That means that they no longer have life insurance coverage, and no death benefit will be paid out to beneficiaries upon their death. They may also have to pay a "surrender charge," and will almost certainly owe taxes on the amount cashed out.
Many permanent life insurance policies offer the chance to cash out prior to death, if certain circumstances apply. For example:
If a policyholder is unsure whether a policy offers these "living benefits," they should call the insurance company to find out. Even if a policy does not cover the entire cost of long-term care, it can certainly be of assistance.
Keep in mind: If the policyholder otherwise qualifies for Medicaid assistance, hold off on cashing in life insurance benefits until the policyholder (or their representative) gets a clear picture from Medicaid of how it will impact potential benefits.
If a policyholder has trouble making premium payments, there may be a short-term solution. As long as the policyholder has paid into the policy long enough to have accumulated cash, they can ask the insurer to use that accrued cash to pay the policy premiums. Let's say a person has lost their job, but wants to make sure premiums are paid until they find new employment. Using accrued cash to pay those premiums keeps the policy in effect, giving them one less thing to worry about.
Keep in mind: Once the policy's cash value has been depleted, the policyholder will need to make payments again -- otherwise, the insurer can cancel the life insurance policy.
Of all the things to consider before taking cash out of a life insurance policy, taxes must be near the top of the list. For an example of why, let's go back to the scenario of the person who only purchased a policy because they owned a business and wanted to protect their partner's interests if they died.
Let's say this person paid $40,000 in premiums over the years, and ended up with $120,000 in cash value. They surrender the policy in return for the cash value in the account. As far as the IRS is concerned, $80,000 of that cash is taxable, because it represents how much the investment grew.
The smart move before withdrawing cash from a life insurance policy is to know how much of that cash must go toward paying taxes.
RELATED: Is life insurance taxable? See our complete guide on life insurance and taxes.
Say a policyholder has amassed a small fortune and has no concerns about whether their beneficiaries will be taken care of following their death. Surrendering a policy and taking the cash value at that point may make sense.
Another time a person might consider canceling their coverage is when their investment strategy has changed. Let's say a person initially purchased an indexed universal life policy, because they liked that it's tied to a major stock market. Later, they decide they would rather use the money they've poured into premiums to make other types of investments. It is possible that cashing out their life insurance policy at that point makes financial sense.
Word of warning: Selling a permanent life insurance policy to a third party is never recommended, no matter how quickly they promise cash. These companies often prey on people desperate for cash, and pay pennies on the dollar. In addition, once they purchase a policy, the third-party company receives the death benefit when the policyholder dies, leaving the original beneficiaries out in the cold.
The answer to the question "Can you cash out a life insurance policy" is yes. There are at least five ways to cash out life insurance:
Using cash from a life insurance policy to pay debts can be financially dangerous. If a person still has beneficiaries to look out for, it is risky to put a life insurance policy on the line. It may make sense to take cash from life insurance if you're at the end of your life and need the money for healthcare or no longer need a death benefit.
The length of time varies by the insurance company. In most cases, cash value does not begin to accrue until a policyholder has made premium payments for two to five years.
The cash value depends on how much premium payments are, what portion of the premiums go toward building cash value, and how many years the policyholder has paid into the account.
Cash surrender value means the policyholder gets the cash that has built up in the account (minus surrender fees and taxes) in return for ending the policy.
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