Older workers who find themselves unable to find a new job or retirees confronting a health crisis and its associated costs, often turn to their life insurance policy as a source of ready cash. Is it a good idea?
There’s no easy answer to the question of cashing in a whole or permanent life insurance policy. If there’s no other source of cash, even temporarily, it may be the only answer. On the other hand, according to the discussion presented in “Cashing in Your Life Insurance Policy” from Investopedia, if you are relatively young and the insurance policy was purchased to protect your family’s financial future, there may be some long-term risks.
Cash-value life insurance, like whole life and universal life, builds reserves through excess premiums plus earnings. These deposits are held in a cash-accumulation account within the policy. You can access cash accumulations within the policy through withdrawals, policy loans, or partial or full surrender of the policy. Another alternative is selling your policy for cash, known as a life settlement. Note that although cash from the policy might be useful during stressful financial times, you could face unwanted consequences depending on the method you use to access the funds.
You can usually withdraw limited cash from a life insurance policy, based on the type of policy you own and the insurance company. The big advantage is that the withdrawals aren’t taxable up to your policy basis, as long as your policy isn’t classified as a modified endowment contract (MEC). However, these can have unexpected or unrealized consequences. Withdrawals that decrease your cash value, could cause a reduction in your death benefits. This is a potential source of funds you or your family might need for income replacement, business purposes or wealth preservation. Cash-value withdrawals also aren’t always tax-free. If you take a withdrawal during the first 15 years of the policy, and the withdrawal causes a reduction in the policy’s death benefit, some or all of the withdrawn cash could be subject to tax. Withdrawals are treated as taxable, to the extent that they exceed your basis in the policy.
Withdrawals that reduce your cash surrender value could mean higher premiums to maintain the same death benefit, or the policy could lapse.
If your policy is determined to be an MEC, withdrawals are taxed, according to the rules applicable to annuities–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’re under age 59½ at the time of the withdrawal. Policy loans are treated as distributions, so the amount of the loan up to the earnings in the policy will be taxable and could also be subject to the pre-59½ early-withdrawal penalty.
Surrendering the policy can provide the cash you need, but you’re relinquishing the right to the death-benefit protection. You can sell your life insurance policy to a life settlement company in exchange for cash. The new owner will keep the policy in force (by paying the premiums) and get a return on the investment, by receiving the death benefit when you die.
To qualify for a life settlement, the insured must be at least 65 years old, have a life expectancy of 10 to 15 years or less, and usually have a policy death benefit of at least $100,000. However, the taxation of life settlements is complicated. The gain in excess of your basis in the policy is taxed to you as ordinary income. In addition to the tax liability, life settlements usually include up to a 30% in commissions and fees, which reduces the net amount you receive.
There may be other alternatives to liquidating a life insurance policy for cash. Before you make the decision, think about why the policy was purchased, and what is at risk, if the policy is gone. Other options may include a home equity loan or borrowing against a 401(k) loan. All of these options have their own pros and cons, but should be thought through before going forward. You may have to ask yourself what is the “least bad decision” you can make.
Reference: Investopedia (January 9, 2019) “Cashing in Your Life Insurance Policy”