Tax Penalties for Cashing Out a Life Insurance Policy Early
But at a certain point, you may realize that you no longer need life insurance. Maybe you get divorced and no longer have financial dependents to support. Perhaps your financial situation changes, and you need to access money quickly.
In either case, you may be able to get money from your life insurance policy through a process called cashing out. Although cashing out life insurance has benefits, it also has a few drawbacks, namely, when it comes to penalty fees and taxes.
If you're considering cashing out your life insurance policy, here's what you need to know to make your decision, including the tax penalty for cashing out life insurance.
Note that although Ethos sells whole life policies that carry a cash value, our competitively priced offerings are designed for a fast, trustworthy, and hassle-free experience, and should not be a primary investment vehicle. The information given here is intended to inform you as you make decisions about your life insurance coverage. Always speak with a trusted financial advisor before making significant financial decisions.
What does it mean to cash out your life insurance?
Cashing out your life insurance, sometimes referred to as "cashing in," means you're pulling money out of your life insurance policy before you pass away. The money can be used for any purpose, though it's subject to early withdrawal fees and taxes.
Although cashing out can give you access to quick money, you can't cash out for your policy's total value or face value. So, for example, if you purchased a policy with $1 million in coverage, you can't cash out your policy and receive a $1 million payout.
Another thing to know is that cashing out isn't an option for everyone. You can only cash out with a permanent life insurance policy like whole life insurance or VA life insurance.
Term life insurance policies can't be cashed out because they don't build cash value, which is the source of the money that you can claim.
So, what is cash value? When you pay your life insurance premium, a portion of the payment goes into a cash value savings account. The money grows at a fixed or variable interest rate, and once the account reaches a certain balance, you can borrow some or all of the money in times of financial need.
How does cashing out a life insurance policy work?
If you decide to cash out your life insurance policy, you typically have a few options. The right choice for you depends on the amount of money you need to borrow, how long you've had the policy and what penalties you could face. Here are a few ways you can collect life insurance cash value:
Withdraw cash value from your policy
Withdrawing cash value from your life insurance is one of the most common ways to access money from your policy.
Depending on the amount you need, you can withdraw a portion of the money or the total balance of your cash value.
However, the cash value you withdraw will be subtracted from your death benefit. For example, if your policy's face value was $500,000 and you withdrew $75,000 in cash value, your beneficiary would only be eligible to receive $425,000 when you pass away.
Take out a loan
Most life insurance companies allow policyholders to take out loans and use their cash value as collateral. You aren't required to pay back the money you borrowed, but if you don't, the money gets subtracted from your death benefit, like with a traditional withdrawal.
Even if you don't intend to repay the money you borrow, you're still responsible for paying interest. If you don't make the interest payments, the money gets taken out of your cash value. And, if your cash value runs out, your insurance company can terminate your policy.
Surrender your policy
The last option is to surrender or cancel your life insurance policy. This isn't always the best choice, but if you can no longer afford the premiums or have already paid off your debts, having a life insurance policy may no longer make sense.
When you surrender your life insurance policy, you must go through a formal cancellation process with your insurance carrier. Your coverage ends, and your beneficiary is no longer entitled to a death benefit. You typically get to keep the unused cash value from your policy, minus any surrender fees.
What are the penalties for cashing out life insurance?
Before you cash out your life insurance policy, it's important to understand the penalties you could face. Often, cashing out life insurance costs money, either in the form of fees or taxes.
If you decide to surrender your life insurance policy, you may have to pay a surrender fee. Unlike term life insurance, you usually can't cancel a permanent life insurance policy for free.
Surrender fees often depend on the length of time your policy has been in force and the number of premiums you've paid into the policy. The longer you've had your policy, the smaller the fee is, in most cases.
You can ask your insurance provider to explain what surrender fees you'd be required to pay before canceling your coverage.
Federal income taxes
When you cash out your life insurance, whether you borrow cash value, take out a loan, or surrender your policy, the money deposited into your savings or checking account gets taxed.
For instance, imagine you've paid $50,000 in life insurance premiums over 10 years. When you cash out, your cash value has grown significantly and is now worth $150,000. When that money hits your bank account, the IRS considers the $100,000 investment gains taxable income.
Life insurance withdrawals are taxable based on your income tax bracket. Be sure to speak with a financial advisor or CPA to help you understand what taxes you'll owe before you cash out your life insurance policy.
How to get life insurance through Ethos
Life insurance is an excellent investment for most people, even if you have substantial savings. Some of the risks of living without life insurance include passing your debt onto family members when you pass away and missing out on valuable tax benefits.
Through Ethos, you can purchase term life insurance in 10 to 30-year increments and whole life insurance. Medical exams aren't required, simply answer a few health questions on the application.
You can get a free quote online and apply in less than 10 minutes. Are you wondering: how much insurance do I need? Simply use our free coverage calculator to choose an appropriate amount of coverage for yourself and your family.