If your life insurance policy has cash value, you can take out your money whenever you want through a cash surrender. The insurance company will cancel your policy and mail you a check for your account balance. Before making a cash surrender, review the tax consequences of this decision and consider whether it makes sense to end your coverage or take your money out through a loan.
Cash Value for Life Insurance
You can only cash surrender permanent life insurance policies, as they are the only policies that build cash value. Term policies do not build cash value.
When you buy a permanent policy, your cash value is at first a buildup of your premium payments. Over time, the insurance company invests your money, and the account balance grows. Whole life policies pay a guaranteed fixed rate of return on your money, while variable policies invest your money in the stock market. As long as the investment gains stay in your insurance policy, they are not taxable.
Cash Surrender Option
When you surrender your life insurance policy, you get your premium payments back tax-free because you funded your life insurance with after-tax money, and the IRS doesn't double-tax your contributions. While your premiums are returned tax-free, your investment gains are taxable.
By surrendering your policy, you take out all your money at once, so you must pay tax on your gains immediately. To calculate your taxable income from the surrender, subtract your total premium payments from your cash value. Whatever is left over is taxable.
Cash Surrender Considerations
Consider other issues aside from taxes before surrendering your policy. When you cash surrender your life insurance, your insurance protection ends. If you die after ending the policy, your heirs won't receive a death benefit.
If you want life insurance protection, you'll need to buy a new life insurance policy. This can be a problem if your health has worsened since you bought the original policy. Insurance companies can deny you coverage based on poor health. If you still need insurance protection, determine if you can qualify for a new policy before surrendering your old one.
Taking Policy Loans
If you want to take out your cash value, you can take out a loan instead of surrendering your policy. The IRS doesn't tax loans, so you get your gains out tax-free. If you never cancel your policy, you never owe taxes on your gains.
When you die, the loan will get paid out of your death benefit. Since death benefits are income tax-free, your heirs won't owe taxes on your gains either.
The downside of taking a loan is that you'll need to keep paying your insurance premiums. Your death benefit will also be reduced by the amount of your loan.
David Rodeck has been writing professionally since 2011. He specializes in insurance, investment management and retirement planning for various websites. He graduated with a Bachelor of Science in economics from McGill University.