What happens when a policyowner borrows against the cash value of his life insurance policy
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Life insurance can be used as a flexible financial tool to cover a variety of basic protection needs and planning strategies. Your life insurance policy offers death benefit protection to help provide financial support for a surviving spouse or income for a child, family member or dependent with special needs. It could also go toward estate taxes, provide funding to buy out a business partner or yield financial support for a charity or community organization. Show
But the benefits of
life insurance aren’t only for survivors. There are also ways to access the value of a policy during the policyowner’s lifetime. In fact, what you do with these funds during your lifetime could be just as important as the protection your policy provides for your heirs. Policyowners may find a policy’s cash value helpful when a major expense or the need for ongoing care arises. If policyowners face certain health conditions, they might take advantage of living benefits, which are generally
optional supplements available with the policy for an additional cost. One caveat is that before you consider accessing your life insurance policy during your lifetime, talk with your financial or tax professional about any tax implications. Here are four paths to access the value of a life insurance policy while the insured is still alive. Draw on its cash value If you own a cash value life insurance policy, including all forms of universal (sometimes called
permanent) life insurance, you may build underlying cash value over time, which can be accessed while keeping at least a portion of the policy’s death benefit intact. Policy loans: Borrow against the available cash value of your life insurance policy. Provided that your policy has sufficient remaining cash value to pay ongoing charges, your policy’s death benefit will remain the same. Policy loans generally offer lower interest rates than bank loans and can be repaid at your
convenience. Any outstanding loan debt (the balance plus any accrued interest) will be deducted from the death benefit at the insured’s death. Withdrawals: You can take withdrawals from the policy’s available cash value without interest charges. A withdrawal charge may apply and any policy withdrawals will reduce policy values and may reduce benefits. Withdrawing a sum too large could decrease the death benefit or affect the terms of your policy, but a withdrawal may be an
easy solution if your policy has such a feature. Policy surrender: In many cases, you also have the option of canceling the life insurance policy and receiving a cash payment for its net cash surrender value (the policy’s accumulated cash value less any outstanding policy debt and surrender charges). Because surrender charges may apply for many years after a policy is issued, the net cash surrender value is generally higher the longer you own the policy. With policy surrender,
you won’t owe interest or need to repay as you would with a policy loan. You do, however, give up the life insurance policy and lose any death benefit you might have planned on for your survivors. Take advantage of living benefits If you meet certain criteria, you may be able to tap into a portion of your policy’s death benefit during your lifetime through living benefits. Living benefits are either included when the policy is issued or available as optional riders*
with most life insurance products. For example, if major health issues arise, you may be eligible for living benefits. Be aware that taking living benefits will reduce your life insurance policy’s death benefit and cash surrender value and may impact the availability of your policy’s other optional benefits. Consult a financial professional to discuss whether living benefits may be useful. Cash value life insurance policies provide lifelong coverage combined with an investment account. A portion of your premiums are directed to the investment account — the cash value — and this money grows with interest over time. If you decide to cash in your life insurance early and surrender your coverage to the insurer, you will receive the policy’s cash value (minus fees). You can also access the cash value as a policy loan, use the cash value to pay premiums or make a partial withdrawal. What is cash value life insurance?Cash value life insurance refers to any life insurance policies that not only have a death benefit but also accumulate value in a separate account within the policy. Each time you make a premium payment, the money is split among three different categories:
A life insurance policy’s cash value is separate from the death benefit, so your beneficiaries would not receive the cash value if you passed away. Any cash value that’s left in your life insurance policy when you die is kept by the insurer. A life insurance policy’s cash value is essentially the amount of money you would receive if you decided to give up the policy to the insurer, or surrender your coverage. The cash value behaves like an investment as it grows tax-deferred with interest, as determined by the type of policy, and can be used as collateral for a loan. Even though the cash value’s growth is tax-deferred, it will still take several years of compound interest to grow meaningfully. Plus, for the first several years of coverage the majority of your premiums are eaten up by the cost of insurance and fees, so cash value accumulation is slow. That's why we generally don’t recommend a cash value life insurance policy if you’re fairly advanced in years. The older you are, the more likely that the cost of your premiums will outweigh any eventual benefit you see. If you need a permanent life insurance policy to cover estate taxes or leave an inheritance, guaranteed universal life insurance provides lifelong coverage with little to no cash value component. Types of cash value life insurance policiesCash value life insurance policies are typically permanent, meaning you have coverage for the entirety of your life so long as premiums are paid. Some of the most common types of cash value life insurance policies are:
Term life insurance policies have no cash surrender value. This means that if you decide to give up your coverage to the insurer, you won’t receive anything in return. On the other hand, it’s also the reason why term life insurance is several times less expensive than cash value life insurance. The only reason you’d get money back from an insurer with a term life insurance policy is if you have a return of premium rider. This rider adds to the cost of your premiums but ensures that you’ll receive a portion or the sum of premiums paid if you live past the term of the policy. Dividends and participating cash value life insurance policiesMutual insurance companies don’t have shareholders and are, in essence, owned by their policyholders. Therefore, if the insurer makes more money than is needed to run the business, they pay some of it back to policyowners in the form of a dividend. If you have a participating cash value life insurance policy, it means you’re eligible to receive a dividend. Dividends are not guaranteed, but most of the top mutual insurance companies have consistently distributed them for decades. Dividends are distributed according to the size of your cash value. For example, if Jane had $20,000 of cash value and John had $10,000 of cash value, Jane would receive a dividend twice the size of Jon’s. You can take dividends as cash, use them to pay premiums or use them to buy additional coverage. What is 7702 life insurance?Cash value life insurance policies are sometimes referred to as 7702 life insurance. This just means that they’re compliant with section 7702 of tax regulation. Life insurance policies have a variety of tax benefits, such as the death benefit paid to beneficiaries being free of income tax. Section 7702 was created to limit what could be considered as a life insurance policy and make sure other investments weren’t reaping the same tax benefits. How to access the cash value in your life insurance policyPremiums for cash value life insurance can be incredibly expensive, so it’s important to understand all the ways you can take money out of your life insurance policy. Whether you want to get rid of your coverage and cash out your life insurance or simply take out a loan, there’s a variety of ways to take advantage of your policy’s cash value. Even if you no longer want coverage, make sure not to let your policy lapse at any point. When a policy lapses, you lose the death benefit as well as any cash value you could have been paid. Pay your premiums with the cash valueVariable and universal life insurance policies are often favored because they allow you to use the policy’s cash value to pay premiums. This strategy will only work for a short period of time if you start while the cash value is too small or if interest rates are low. In addition, you have to carefully monitor the cash value to make sure it doesn’t drop too far, or you may lose your coverage. But if you have a fairly large cash value with consistent returns, you can keep coverage in place for years at little to no additional cost. For example, say your annual premium is $5,000 and you have $100,000 in cash value. You would just need the policy’s cash value to return a net 2.5% interest annually to cut your premium payments in half while maintaining the full cash value. Whole life insurance policies typically don’t let you pay premiums using the policy’s cash value except if you convert to a paid-up policy. Not all insurers offer this option but, with a paid-up life insurance policy, the cash value is large enough that you can stop paying premiums out of pocket. You use the cash value to pay premiums. The downside to paid-up whole life insurance policies is that each premium payment is deducted from the policy’s death benefit. In addition, less cash value is available for other purposes, such as a policy loan. Put up cash value as collateral to borrow from your insurerA life insurance policy loan is a loan from the insurer in which the cash value of your policy is used as collateral. It can be used for paying medical expenses, buying a car or anything else you might need cash for. Since the insurer holds the funds to cover the loan:
However, if you pass away while the loan is outstanding, the value of the loan will be deducted from the death benefit your beneficiaries receive. Borrowing against your policy’s cash value is simple and typically comes with quite low annual interest rates. But you need to either pay interest out of pocket annually or carefully monitor the size of the loan as compared to the policy’s cash value. If you don’t make interest payments, the interest amount is added to the outstanding loan balance. If the total size of your loan ever exceeds your policy’s cash value, the life insurance policy will lapse, canceling your coverage. In addition, you will likely have to pay income tax on the loan. Sell your policy for a life insurance settlementIf you want to give up your coverage and cash out your life insurance policy, you should first try to sell it in a life insurance cash settlement. You might want to do this if your premiums are high and you no longer have dependents, or they’re all financially secure. In a life insurance cash settlement, a company buys your life insurance policy for an amount that’s greater than the cash value but less than the death benefit. Some companies even buy term life insurance policies for cash, but only if you’re quite old or sick, so likely to pass away during the policy term. You’ll have to pay income and capital gains taxes on the settlement. Be aware that any brokers that help pair you up with a settlement company will typically take a cut. But the net effect is that you will usually get more money than you would by surrendering your policy. Once the policy is sold, the life insurance settlement company takes over premium payments and becomes the policy beneficiary. The downside is, you won’t always find a buyer and the process of being evaluated by a life insurance settlement company can take several weeks. Surrender your life insurance policy for its net cash valueIf you can’t get a settlement and want to cash out your life insurance, you can surrender your policy to the insurer. Simply let your insurer know and they will pay you the life insurance policy’s net cash value. The net cash value is the "actual" surrender value of the policy. You will typically find it listed separately in your life insurance statements. The net cash value will generally be lower than your total accumulated cash value for the first several years of coverage as it’s reduced by fees and surrender charges. However, if you’ve had your policy in place between 10 to 15 years, the net cash value is likely to be close or equal to the total accumulated cash value. Make a partial withdrawal of the cash valueIf you don’t want to get rid of your life insurance coverage entirely but have fewer financial obligations, you can also withdraw a portion of the cash value. This provides you cash while reducing the life insurance policy’s death benefit. For example, if your children have done well in their careers, you may be less concerned about passing on an inheritance but still want some coverage for your spouse. How a partial withdrawal works can vary based upon the life insurance policy:
Increase your death benefit with paid-up additionsIf you have a sizable cash value but don’t have a use for it, you may be able to increase the amount of money left to your beneficiaries. This option isn’t always available, so you’ll need to check with your insurer, but it’s a simple way to make sure your family doesn’t just lose the cash value you’ve built up over time. Similarly, if you have a participating whole life insurance policy from a mutual insurer, you can use any dividends you receive to purchase paid-up additions. Buying paid-up additions is similar to buying a small single-premium life insurance policy as you increase the policy’s cash value and death benefit but don’t have ongoing payments. Finally, there are no medical exams or underwriting requirements involved in buying paid-up additions, so you can increase your coverage even if your health has gotten worse. What happens when a policyholder borrows against the cash value of his life insurance policy?Length of the loan
And if the total outstanding loan reaches the size of your policy's cash value, the policy will lapse. If this happens, you will lose your coverage plus get hit with a high tax bill if the outstanding loan is greater than the amount you've paid in premiums.
What happens if a loan taken out against the cash value of a life insurance policy is not repaid before the insured's death?If the loan isn't repaid before the insured person's death, the insurance company will reduce the face amount of the insurance policy by what is still owed when the death benefit is paid. In other words, if you're the policyholder, your beneficiaries get less when you die. So pay back those loans.
Can cash value be borrowed against a whole life policy?As cash value builds in a whole or universal life insurance policy, policyholders can borrow against the accumulated funds. Life insurance policy loans have one distinct advantage: The money goes to your bank account tax-free.
What does it mean when a life insurance policy has a cash value?With a cash value life insurance policy, a portion of each premium you pay goes toward insuring your life, while the other portion goes toward building up a cash value. The cash value portion of your policy accrues tax-deferred interest.
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