Your life insurance policy may be a possible revenue source, but is it wise to cash out life insurance?

Let’s take a look at cash value life insurance, how you can cash out a life policy and the benefits and negatives of drawing from your life insurance.

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Key takeaways:

  • Permanent life insurance policyholders can typically tap into the cash value of their policies while they’re still alive. The policies gain cash value as you pay premiums.
  • You may also get money from permanent life by cashing out your life insurance policy.
  • Policyholders may also be able to sell life insurance for cash, which is called a life settlement.
  • Selling or canceling your policy can get you money, but also leaves your beneficiaries without a death benefit when you die.

What type of life insurance has a cash value?

Permanent life insurance provides cash value. When you make a payment on these policies, the insurance company sets aside a portion of it for cash value, which you can tap into.

These cash value life insurance policies include:

  • Whole life
  • Variable universal life
  • Indexed universal life

Cash value life insurance -- such as whole life, variable universal life and indexed universal life -- covers an insured's entire lifetime and features a cash value account. A policy's cash value functions as a sort of long-term savings vehicle and that amount of money grows tax-deferred over time.

With cash value life insurance, policies allow you to borrow from the value of your life insurance or use it to pay policy premiums once it's reached a certain level. When you use the cash value in that way it's called being "paid up." If you take out a loan on your life insurance, you'll want to pay up the loan amount before you die.

If you die with an outstanding loan balance, the money will be deducted from the death benefit, so your beneficiaries will receive less from your insurer. Also, a non-loan withdrawal from life insurance policies are taxable at your ordinary income tax rate.

Also, borrowing from your life insurance policy's cash value will likely come with interest, which you will have to pay back, too. That interest will probably be lower than if you used a credit card to borrow money or took out a bank loan. Getting cash from your life insurance will also not show up on your credit report unlike credit cards and bank loans.

Although the cash value can serve as a valuable financial resource while you're alive, it disappears when you die. With most policies, the beneficiary is paid the benefit when you die, and the life insurance company absorbs the cash value after your death.

Cash value life insurance rates are usually higher than term life

Insurance companies typically charge higher life insurance rates for permanent life insurance than term life. The higher premiums are because the life insurance company knows it will eventually have to pay a death benefit and permanent life policies have the added benefit of cash value.

However, term life, which provides coverage for a period, such as 10, 15 or 20 years, doesn’t have cash value. Instead, term life pays a death benefit to the policy's beneficiary if you die within the term -- but you can’t tap into the policy while you’re alive.  So, there's no cash surrender option for term life.

How can I cash out life insurance?

Policyholders can make cash withdrawals or loans against most permanent life insurance policies. Another option is to cancel your policy, which would allow the cash value to go back to the policyholder minus any fees.

"You can borrow or take partial surrender of life insurance additions with whole life insurance. With universal life insurance, you can surrender from the accounting value," said Paul Lapiana, CFP, head of MassMutual US products.

The downside of canceling your life insurance is that you lose the death benefit.

Surrendering a life insurance policy

Surrendering your policy may help in the short term but could have a lasting effect on you and your family.

Depending on the kind of life insurance policy, you could get money back when you cancel it, which is called surrender value. This is true of whole and universal life insurance, which builds interest. Term life insurance is different -- with this type, you just cancel the policy and move on with your life.

Regardless of the type of policy, once you surrender your policy, it’s gone. There will be nothing to pay out to your benefactors when you die.

Selling a life insurance policy for cash

Known as a life settlement, selling your life insurance policy for cash is possible.

There are companies or brokers who handle these types of sales, which usually take a few months to finalize. The outcome is that you no longer make monthly premium payments and when you die, the new owner receives your insurance payout.

On the plus side, it may help to not have the monthly payments and you receive cash if there's any value built up in your policy. But remember, that means your life insurance policy is gone.

Requirements for a life settlement

There are a few requirements for a life settlement:

  • Policyholder needs to be 65 or older
  • Policy needs to be larger than $100,000
  • If it’s a term policy, it has to be converted to permanent

Frequently Asked Questions

Do you pay taxes on life insurance cash out?

You can withdraw up to the amount that you have paid in premiums on a life insurance policy -- minus fees -- and not pay taxes. If you withdraw more than you have paid, the additional amount will be taxed.

"You can withdraw or surrender up to the cost basis tax-free,” Lapiana said.

Which type of life insurance policy generates immediate cash value?

Most whole life insurance policies have some initial cash value, Lapiana said.

Remember to weigh the pros and cons of tapping into a whole life insurance policy, especially if you’ve only had it for a short time and haven't built up a value of your policy yet.

How long does it take to cash out a life insurance policy?

Cashing out a policy generally takes one to two weeks.

What are the tax consequences of cashing in a life insurance policy?

If you withdraw money from the cash value policy, once you exceed the amount you've already paid in premiums, the rest is taxable.

Also, something to keep in mind, although most whole life insurance policies allow you to withdraw money at any time, some have restrictions. For instance, some whole life policies may make any withdrawals in the first few years taxable.

As always, reaching out and speaking to a professional is your best bet as a starting point. Contact the life insurance company or talk to your life insurance agent to discuss options.