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Cashing out your life insurance policy

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With all the various forms of life insurance available, it can be hard to know the difference between them and which is the best fit for you. In this article, we’re going to cover what you need to know about cash value life insurance, including different types of cash value policies, who needs this type of policy and the pros and cons involved.  

What is cash value life insurance?

Cash value life insurance is an insurance policy that provides a death benefit and accumulates money into a separate account. Every premium payment, whether monthly or yearly, gets separated into three different categories:

  1. Insurance cost: This money goes toward the death benefit.
  2. Fees: This is what the insurance company takes for its expenses. 
  3. Cash value: This is the part of your insurance policy that gains value. 

Any of the cash value portion of the policy not used prior to your death will be taken by the insurance company. The cash value is an investment that grows with interest and is tax-deferred. It can be used as collateral for a loan, or you can surrender your insurance policy and receive the cash value. 

It will take a few years to get any cash value from your life insurance policy as your premiums will first go to the insurance cost and fees. After a few years, you will start to grow the cash value and be able to use it. For this reason, it’s not a recommended life insurance policy for older people.  

Types of cash value life insurance policies

There are four primary types of cash value life insurance policies. All of these policies are permanent, meaning they stay with you for life unless you stop paying the premiums, or you surrender the policy. The commonality with these is that they all have a cash value portion; they just grow the cash value in different ways.

Whole life insurance

The insurance company determines the fixed rate at which the whole life insurance policy grows. It’s designed to match the size of the death benefit when the policy matures. You’ll pay a fixed premium (monthly or yearly), which does not change. A portion of what you pay goes into the cash value, which doesn’t change either. If you start with a return of 2%, it will remain at that rate for the life of the policy. 

Universal life insurance

The cash value in a universal life insurance policy depends on how well the insurance company does and what the market interest rates are. It’s different from whole life insurance because the premiums and death benefit can change. If you have extra money to put in, you can send that in with your premium and put it towards your cash value. 

Indexed universal life insurance

The cash value in an indexed universal life insurance policy depends on how well an index is doing, such as the S&P 500. 

Variable life insurance 

The cash value in a variable life insurance policy depends on how well the various investments do, and there could be up to 50 funds to pick from. The difference with this policy is that you choose how your money is invested (stocks, bonds or money markets). The premiums on this policy are higher as well compared to other forms of life insurance. 

Who needs cash value insurance?

Cash value insurance policies provide financial benefit while you’re alive. The cash value can be withdrawn or used as collateral for a loan. Also, if you decide to surrender your life insurance policy, you will get the cash value back. A term life insurance policy has no cash value, and you will get nothing if you choose to surrender your policy. 

So, anyone who needs a savings account (which cash value essentially is) built into their life insurance policy would benefit from cash value insurance. If you can afford the premiums, why not benefit from your life insurance policy while you’re still alive and leave your family financially taken care of after you’re gone?

Why cash out your life insurance policy?

There are many reasons why you might need to cash out your life insurance policy during your lifetime. You might need the money to pay medical bills or any other unforeseen expenses for which you don’t currently have the cash. 

There are some pros and cons to cashing out a life insurance policy to consider:

  • Cashing out your life insurance policy can have tax implications, especially if the withdrawal is made within the first 15 years of the life of the policy. 
  • Reducing your cash value (which is usually a consequence of withdrawal) can reduce your death benefit as well, leaving your loved ones with less than they need. 
  • It can increase your premiums, causing you to pay more each month or year, just to keep the same death benefit. 
  • If you have a life insurance policy that is classified as a Modified Endowment Contract (MEC), then you could pay income tax and an early withdrawal penalty fee of 10%. 

How to get cash from your life insurance?

There are a few different ways to get cash from your life insurance:

Loans

Use the cash value in your life insurance as collateral to get a loan. In this case, you are borrowing directly from your insurer. One downside to this is that it can decrease your death benefit. You won’t need to make payments on this loan, but you’ll still be accruing interest. 

Policy surrender

You can surrender your life insurance policy to receive the cash value in full. However, you might have to pay early termination fees depending on how long you’ve had the policy. You also might have to pay income tax. In this case, you are giving up any rights to the death benefit since you are canceling your policy. 

Life settlement

In this scenario, you are selling your life insurance policy for a lump sum, either to an individual or a settlement company. The new owner, whether an individual or settlement company, will continue to pay your premiums and receive the benefit upon your death. 

The takeaway

  • Cash value life insurance policies can be beneficial if you can afford the high premiums and want to leverage cash options throughout your life. 
  • Taking cash out of your policy can have some disadvantages, so be sure to speak with your agent to make sure you understand all the details. 

A cash value life insurance policy can be a great investment, but make sure you understand the implications of all of the details. You could have some serious consequences if you ever need to cash out your policy. Look at all of the pros and cons before you choose which policy is right for you, and whether to cash out your policy if that time comes.

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