Life insurance is a cost-effective way to secure the financial well-being of your loved ones. But some policies, such as whole life and universal life insurance, provide benefits to you (the policyholder) as well.
Alongside lifelong coverage, these policies build up cash value, which you can withdraw or use as loan collateral at any time. Regardless of which option you use, cashing in your life insurance policy may have several financial implications, including tax liability.
Keep reading to find out how to access your policy’s cash value, when is the best time to do so, and the financial implications of cashing in life insurance.
How can I access cash value from my whole life insurance?
With whole life insurance, cash value grows at a fixed rate set each year by the insurance company. Once your cash value grows to a sizable amount, you can access it and use the funds however you like.
You can get to your cash value in one of the following ways:
1. Making a cash value withdrawal
You can withdraw money directly from your policy’s cash value. But keep in mind that doing so means your beneficiary will not get the full death benefit upon your death.
Generally, for each withdrawal, the death benefit gets reduced on a dollar-for-dollar basis. So if you withdraw $50,000 from a policy with a face value of $200,000, your beneficiary will receive $150,000 ($200,000 - $50,000) when you pass.
Cash value withdrawals are tax-free up to the policy’s cost basis. Your policy’s cost basis is the amount you have paid in policy premiums while the “above basis” is the interest gains earned on the cash value.
Continuing with the example above, your policy’s cost basis was $42,000 at the time of the withdrawal. This means you will receive a tax bill on only $8,000 ($50,000 - $42,000) — not the entire amount you withdrew.
2. Taking out a policy loan
You can borrow money from the insurer using the cash value as collateral. So in a sense, a policy loan is a type of secured loan. As a result, interest rates are quite low, but that is not the only reason to consider a policy loan when facing financial difficulties.
Unlike other loans, policy loans have no eligibility requirements and offer repayment flexibility. Since you are borrowing your money, you automatically qualify for a policy loan the moment your policy’s cash value crosses a certain threshold. And since there is no credit check, a policy loan does not hurt your credit score. Nor will it appear on your credit report, which can make securing additional funding easier.
The longer a policy loan lasts, the more interest it accrues. Once the loan’s value equals the policy’s face value, the coverage terminates.
A policy loan is not taxable as long as your life insurance policy is active. But you may get a tax bill if you terminate the policy. In that case, the amount of loan that exceeds the policy’s cost basis will be taxable.
3. Surrendering the policy
You can get to all of your cash value by surrendering the policy. If you do so, the insurer pays you the net surrender cash value, which is calculated using the following formula:
Net cash value = (Actual cash value) – (Surrender charges + Outstanding loan balance)
While surrendering your policy may give you immediate access to a sizable sum, it is not without potential pitfalls. Knowing about them could help you determine if it is the right option for you or not.
- Surrender charges are typically quite high initially — anywhere between 10% and 30% of the cash value. This, coupled with the fact that cash value grows slowly, makes relinquishing the policy in the first several years of coverage years an unprofitable decision.
- Most advisors recommend waiting at least 10 to 20 for your cash value to grow. Since surrender charges typically last 10 to 15 years, after you take the policy, relinquishing coverage after a decade will give you access to most or all of the cash value you have built.
- The amount you receive over the policy’s cost basis will be taxed at regular income.
- Your policy terminates the moment you surrender it. If you need life insurance later, getting the same coverage will likely prove more expensive or more complicated. For this reason, a partial withdrawal or policy loan may be a better option if you have dependents.
4. Life Settlement
A life settlement means selling your existing life insurance policy to a third party in exchange for cash. Generally, the proceeds of the sale exceed the policy’s cash value but are less than its face amount (i.e. the death benefit).
While a life settlement can provide financial relief when you need cash, you typically need to be old enough or sick enough to qualify. This option is usually available only to people who are at least 65 years old or to those with a shorter life expectancy, such as someone with a terminal illness.
At present, life settlements are allowed only in four Canadian provinces — Quebec, Saskatchewan, New Brunswick, and Nova Scotia. However, before you jump on the idea of doing a life settlement, first check whether your insurer allows it or not.
Some insurers are against life settlements, and if you have a policy from such a provider, you will not be able to sell your policy, regardless of where you live.
What types of life insurance have cash value?
Whole life insurance policies and most universal life insurance policies accumulate wealth. One portion of each premium payment is used for covering the cost of insurance and various administrative charges. At the same time, the other is deposited in a built-in savings account, called cash value.
In the case of whole life policies, the cash value grows at a fixed rate set each year by the insurance company. Also, the insurer — not you — decides how the money in the cash value account is invested. In contrast, universal life plans offer you greater freedom. It lets you choose the investment sub-accounts in which your cash value will be invested.
But the tradeoff is that the cash value growth rate fluctuates depending on the performance of the sub-accounts selected by you. Generally, universal life plans come with a minimum guaranteed annual return rate, which might be 0% or higher.
Regardless of whether you buy a whole or universal life plan, your cash value will grow tax-deferred. In simple terms, this means interest gains or investment gains earned on the cash value get taxed only when you withdraw funds.
Borrowing vs. Withdrawing vs. Surrendering the cash value
Want to tap into your cash value? You have three options:
- A policy loan
- Cash value withdrawal
- Policy surrender
If you borrow money against your policy, you may choose to not repay the loan. But in that case, your beneficiary will get less than the policy’s face value when you pass. Making a partial withdrawal or surrendering the policy are the other two options to access the cash value.
Borrowing from your policy
If you are facing financial difficulties, you may get a leg up from your permanent life insurance policy. Generally, you must wait for a few years to be able to borrow against your policy. Cash value typically grows slowly, and during the initial several years, it is not sizable enough to be used as collateral.
How much you can borrow against life insurance? This may vary from one insurer to another, but usually, policyholders can borrow up to 90% of their cash value.
One of the main benefit of a policy loan is that you are not required to repay it. The insurance company will simply deduct the outstanding loan balance from the death benefit when it pays out.
However, if your death will impact your loved ones financially, it is better to repay the loan. Because you pay interest on the policy loan, over time there may be not much death benefit left for your dependents.
A policy loan is an option if you are in a pinch and can’t get a low-interest loan. You may also want to consider if your life insurance needs have reduced over the years.
Surrendering your policy
If you no longer need life insurance or can’t afford the premiums, cancelling the policy may make sense. To terminate a cash-value life insurance plan, you must call the insurer and inform them about your decision. If you have had the policy for a reasonably long time, say 10 years, you will likely receive most of the accumulated cash value, provided you have not made any withdrawals.
Making a policy withdrawal
You can withdraw money from your cash value to ease your financial worries. But doing so could reduce your policy’s face amount like a policy loan would. Policy withdrawals are tax-free up to your cost basis in the policy. However, any amount withdrawn beyond that is subject to taxation.
What are the benefits of Cash value life insurance?
Cash value life insurance combines lifelong insurance coverage with a savings element. Whether it is a good fit for you depends on your needs, budget, and long-term financial goals. Understanding its pros can help you decide if cash value life insurance is worth the cost.
Your dependents get a lump sum
With cash value life insurance, you get lifelong coverage. This means your beneficiary will eventually receive the death benefit, provided you keep the policy active and maintain a minimal level of cash value. Term life insurance, which lasts for a specific period, doesn’t offer such assurance. It pays out only if the insured’s death occurs during the policy term.
Participating whole life policies offer dividends
Some whole life policies offer annual dividends. These policies are known as participating policies. Even though they are more expensive policies that don’t pay dividends, the opportunity to earn an extra sum of money may be worth the cost. You can use policy dividends in different ways, including buying additional coverage, paying premiums, and reducing the amount of the policy loan.
Cash value grows tax deferred
Funds in the cash value account of your policy accrue interest gains or investment gains, which are not subject to taxation until withdrawn. This strategy offers two potential advantages:
- Your cash value grows faster since it is not being reduced by taxes every year
- You could save a substantial amount by deferring withdrawals from cash value until you are in a lower tax bracket
When should you take out the cash value?
There is no one-size-fits-all answer to this question. It all depends on your life insurance needs and financial situation. While you can withdraw from or borrow against your policy at any time, tapping into the cash value has tax implications and affects the death benefit. If you have dependents, access the cash value only after trying other avenues.
But what if you no longer want to or can pay premiums? As long as you are reasonably healthy, you can buy a term life insurance with the same face value for much less. You could surrender your cash value life insurance policy, purchase a term life plan, and deposit the difference in premiums in investment vehicles that typically give better returns.
Whole life and universal life insurance plans provide lifelong coverage and accumulate wealth. You can access your policy’s cash value by borrowing money against it, withdrawing it, or surrendering the policy.
If you borrow money against your cash value, you will not get a tax bill on the loan while the policy is in force. Repaying the loan is not mandatory, but if you do not repay, the insurer will deduct the outstanding loan balance from the death benefit when you pass.
If you withdraw cash value, any amount that exceeds your cost basis will be subject to taxation. Your death benefit will also be reduced. If you surrender the policy, you will receive the accumulated cash value minus any surrender charges and your policy will terminate. Reach out to a Dundas Life advisor today to learn more.
Frequently Asked Questions
What happens if I don’t use my cash value?
Apart from a death benefit, many permanent life insurance policies accumulate wealth. You can access the money growing inside your policy at any time while still alive by taking a policy loan, making a withdrawal, or surrendering your policy. You can also use the cash value to purchase additional coverage or, in the case of some universal life plans, to pay future premiums. But unless you use the cash value, it usually goes to the insurer — not your family — upon your death.
How much can I withdraw from my cash value?
This depends on several factors, including the total amount of cash value you have and the number of years for which you have had the policy, the type of coverage you have (universal or whole life). Since cash value grows on a tax-deferred basis, the longer you hold on to the policy, the greater its cash value.
Do you pay taxes on life insurance cash out?
If you surrender your policy, you will get a tax bill on that part of the cash value that exceeds the cost basis.
Can I cancel my life insurance and get my money back?
If you cancel your policy during the free look period, which typically lasts up to 30 days, you will receive a refund of the initial premium. But if you cancel coverage after the free look period, you typically will not receive a refund because you enjoyed life insurance protection while the policy was in force.
How soon can I borrow from my life insurance policy?
Usually, it takes a policy several years to accumulate enough cash value to make borrowing money against it possible.