The Financial Consequences Of A Life Insurance Policy Cash Out

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Certain types of life insurance including whole life, universal and variable insurance, allow you to build cash value as you pay your premiums. Unlike term life insurance, these types of policies generally remain in effect as long as your premiums are paid. The longer you pay on the policy, the more cash value you can build up over time. If you find yourself in a financial bind or simply no longer need the insurance, you may choose to sell the policy through a life settlement. If you’re strapped for cash but want to keep the policy, you also have the option of borrowing against your policy’s value. However, before cashing out your life insurance policy or taking out an insurance loan, you need to carefully consider the potential financial implications of doing so.

Loss Of Death Benefit

When you cash out a life insurance policy, your coverage effectively ends, meaning that your spouse and/or children will no longer be entitled to any death benefit associated with the policy. If you have multiple life insurance policies, cashing out one of them may not have a significant impact on your family’s financial well-being. However, if you currently only have one policy in place and are considering cashing out the life insurance because you’re having financial difficulties, doing so could potentially put your family in even more dire straits should something happen to you. Before you sell your cash value policy, you need to ensure that you have sufficient insurance coverage in place to protect your family. While the income you could generate from the policy’s sale may help your situation in the short-term, an insurance cash out could create bigger problems in the long run.

Tax Implications

Whether or not a life insurance cash out is taxable is determined by the policy’s basis. The Internal Revenue Service uses the amount of premiums you’ve paid to the policy to calculate your basis. Generally, if the amount of cash value you withdraw from your life insurance policy is less than the amount of premiums paid, the funds will not be subject to federal or state income tax. However, any amount of cash value you withdraw that exceeds the sum total of your contributions qualifies as income and is subject to taxation.

For example, if you have a $100,000 policy with a cash value of $20,000 and you’ve paid premiums totaling $15,000, the $5,000 difference between the premiums and the cash value would be subject to ordinary income tax. If you withdraw a significant amount of cash value, this could potentially push you into a higher tax bracket, thereby increasing your tax liability. In addition to potentially having to pay taxes on your life insurance cash out, it’s important to keep in mind that your insurance policy issuer may also charge a fee for taking a withdrawal against the policy’s value. Before you opt to cash out your life insurance policy, you may want to speak with a certified account or tax attorney to determine how a cash out could affect your future tax liability.

Repaying A Loan Against Life Insurance

If you determine that selling your life insurance policy may be costly in terms of taxes or you want to keep the policy but still need access to extra cash, you may be able to borrow against the policy instead. Generally, you can use whatever cash value that you’ve built up in the policy as collateral and borrow up to that amount. You can then repay the loan over time and typically there is no set date for repaying the loan in full as long as the policy remains in effect.

Be aware that your insurer may charge you interest for the loan and that borrowing against your insurance may affect future dividends generated by the policy. Even if you’re not required to make regular payments on the loan, you will still need to make payments on the interest. Failure to do so can cause the interest to accrue which can eventually eat away at whatever cash value you have remaining in the policy. If you die before the loan is repaid your beneficiaries will still be entitled to a death benefit but it will be reduced by the outstanding balance of the loan.

When To Consider A Life Insurance Cash Out

There are a number of factors that determine whether a life insurance cash out makes good financial sense. Generally, if you’re in good health, have other insurance coverage or have substantial assets that make the policy unnecessary, cashing out is an easy way to put some extra money in your pocket. If you lack sufficient insurance coverage and are married or have minor dependents, you may want to avoid a life insurance cash out except in situations of extreme financial distress.

For example, if you’re struggling to make your mortgage payments because of a job loss or you or a family member is experiencing a medical emergency, tapping your insurance policy’s value may be your only option if you don’t have sufficient resources to cover your bills. Another possible scenario where a cash out would make sense is if your parents purchased a whole life policy for you as a child as a savings vehicle for future expenses, such as the purchase of a home or to help pay for college tuition.

Cashing out a life insurance policy has its advantages and disadvantages. Before you withdraw from your policy’s value, you should take the time to weigh your options carefully to ensure that you’re making the best decision for yourself and your family.

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Last Updated: May 22, 2012
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About Rebecca Lake Rebecca Lake is a contributing author to CanDoFinance.com. Her work has been featured on Fool.com, the Quicken Money blog and other personal finance sites. Her primary areas of expertise include personal bankruptcy, credit and debt management, retirement planning and paying for college.

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