Cashing in Your Life Insurance Isn’t Always Possible — Or the Best Option

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Life insurance policies are designed to take care of your loved ones after you’re gone, right? Not necessarily. One type of life insurance policy, term life insurance, can only be cashed in after your death. But universal and whole life allow you to cash in your life insurance while you’re still alive.

But just because you can cash in your life insurance doesn’t mean you should. When, how and why you access your life insurance’s value depends on the details of your policy and your beneficiaries. If you’re thinking about cashing in your life insurance, read these tips first.

4 Things to Consider Before You Cash in Your Life Insurance

Cash value life insurance accrues interest over the years you pay into it. It includes both a death benefit and cash value. But cashing in that value isn’t always a good idea. Here are some things to consider before you make that choice.

1. Policy Limitations

Before you can cash in your life insurance, you’ll need to know the restrictions of your policy. Cashing it out won’t be an option if you have term life. Both whole life and universal life policies are what’s known as cash value insurance, which means they earn money you can access before your death. However, the way interest is accrued influences how much money you’ll earn over time.

“Whole life policies have a savings component with a low guaranteed interest rate so they typically don’t accrue a ton of cash value unless the monthly premiums are significant,” said Veronica Fernandez, founder and CEO of Secure Senior Benefits. “Universal life insurance can have both variable and fixed interest rates, with variable universal life offering a higher risk and reward component.”

2. Tax Implications

Before taking money out of your life insurance policy, be aware that some of the funds may be taxable income. You won’t pay taxes on the amount you contributed to the policy. However, you will need to report any proceeds at tax time. This is sometimes costly to older adults who’ve paid a significant amount into their policies.

David Johnston, managing partner at Amwell Ridge Wealth Management, has a potential alternative for older adults. Instead of cashing in the policy, you can shift the funds to a long-term care insurance policy. That covers expenses related to things like nursing home care.

“In doing so, it’s important to note the life insurance policy will cease to exist, and the accumulated cash value will be transferred tax-free to a new asset-based long-term care insurance policy,” Johnston said.

3. Impact on Beneficiaries

While you may need the funds, cash value life insurance still is primarily designed to take care of your loved ones after your death. Taking funds out of that policy will leave less behind for your survivors. That might mean sitting down with family members and explaining the situation.

But as Kendall Meade, a certified financial planner at SoFi, explains, you may no longer need to set money aside for your loved ones. In that case, the decision could be a little easier.

“For those who no longer have dependents or someone relying on their income, they may no longer have a need for the policy,” Meade said. “In that case, it could make sense to surrender the policy or take the cash value out for a big expense.”

4. Surrender Fees

Accredited financial counselor and chartered retirement planning counselor Lisa Whitley has another warning for those thinking of cashing in. “You will want to start by making sure that you will not be liable for any significant surrender fees for cashing in the policy,” Whitley said.

A surrender fee is a percentage insurers charge when they allow you to cash in your policy. This fee will be detailed in your policy, so you should be able to find it fairly easily. This fee will likely be listed as a schedule, with the fee reducing the longer you have the policy. When added to any income taxes you’ll pay, you may find that fees reduce your payout substantially.

Alternatives to Cashing in Life Insurance

Cashing in a life insurance policy can be one way to get funds when you need them. There are a few others, though. Here are some to consider.

Borrowing Against the Funds

If you need some extra cash, taking funds out of your life insurance policy isn’t the only option. In fact, one of the best things about a cash value life insurance policy is that you can use it as security for a personal loan. Known as a life insurance policy loan, this option lets you keep your coverage in place while still accessing the funds. You’ll have to repay the borrowed funds, with interest, as you would with any personal loan.

“Borrowing allows you to retain the policy’s coverage while potentially preserving some death benefit for your beneficiaries,” said Cliff Ambrose, FRC, the founder and wealth manager at Apex Wealth. “However, this action is not without its risks and costs, and it’s crucial to consider the terms of the loan and the impact on the policy’s benefits.”

Borrowing Against Other Assets

Chances are, your cash value life insurance policy isn’t your only asset you can borrow against. You could take out a home equity loan, for instance, or a second mortgage. If you have retirement savings accounts like a 401(k), you may be able to borrow against the funds.

You may not even need collateral to get a personal loan. If you’re comfortable repaying the interest, you could leave your life insurance policy, retirement accounts and home equity in place and borrow funds that you later repay, with interest.

Reduced Paid Up Option

Fernandez has another alternative that can work for some older policyholders. If you want to stop paying premiums into a cash value life insurance policy, you can choose to take a reduced death benefit. This is called the reduced paid up option. The funds in your policy will be labeled “paid up” and rest there until you die. This can free up a little extra money in your monthly budget.

“This option allows them to keep their policy with a reduced face amount and stop making monthly payments,” Fernandez said. “It keeps their family protected but saves them from paying the monthly premium.”

The decision to cash in your life insurance is a big one, and in some cases, it makes sense. Before making that move, though, research the taxes and fees you’ll pay. You may find that an alternative option costs less and gets similar results.

Stephanie Faris is a professional finance writer with more than a decade of experience. Her work has been featured on a variety of top finance sites, including Money Under 30, GoBankingRates, Retirable, Sapling and Sifter.