Cash Value: Loans, Withdrawals and Surrendering a Policy

In this guide

Cash value is the savings component of permanent life insurance, such as whole or universal life. You can usually access it by borrowing against it, withdrawing from it or surrendering the policy, but each choice can reduce the death benefit, trigger charges or create taxes. Understanding the trade-offs, including surrender charges and modified endowment contract (MEC) rules, helps you avoid costly surprises.

How cash value works

The NAIC explains that in a whole life policy, cash value builds over time from your premiums, after fees and insurance costs, and grows untaxed. In universal life, a cash account earns interest and the policy stays in force only while the cash value can cover insurance costs. Growth rates differ by product, and the NAIC advises asking an agent for year-by-year figures.

At death, beneficiaries generally receive the death benefit, not the death benefit plus cash value, although some whole life policies pay both. The NAIC notes that unpaid loans plus interest are deducted from what beneficiaries receive. For the types of policy, see term vs. whole life insurance and universal life insurance explained.

Your options for using cash value

Policy loans

Because you borrow from the insurer rather than withdraw your own money, loans are generally not treated as taxable distributions from a policy that is not a MEC. But interest builds, and if the loan plus interest grows larger than the cash value, the policy can lapse. In that case, the loan may become taxable. Unpaid loans also reduce the death benefit. Ask the insurer for illustrations showing what happens if you do not repay.

Withdrawals

Withdrawals from a policy that is not a MEC are generally treated as coming first from the premiums you paid, which are not taxed, and only afterward from gains. Policy terms vary, and withdrawals often reduce the death benefit. Check the contract before you withdraw.

Surrendering a policy

When you surrender, the insurer pays you the cash surrender value, which is the cash value minus any surrender charges and outstanding loans. The coverage ends. If the amount you receive is more than your total premiums paid, the excess is generally taxable as ordinary income. Talk with a tax professional about your numbers.

Surrender charges

Many permanent policies charge a fee for surrendering in the early years, which is designed to recover the insurer's costs. These charges often decline over time and may disappear after a set number of years. The schedule is in the policy. State nonforfeiture law, as the NAIC notes, requires that if a whole life policy lapses for missed payments or is surrendered, the policyholder receives non-forfeiture values in cash or other insurance options. The specific amounts depend on the contract.

• Ask for the surrender value schedule, not just the cash value.
• Compare surrendering with keeping the policy and reducing premiums.
• Look for non-forfeiture options such as reduced paid-up insurance or extended term insurance, if available.

Modified endowment contracts (MECs)

Federal tax law limits how much premium can go into a policy before it loses some of its tax advantages. Under section 7702A, a policy fails the "seven-pay test" if the premiums paid during the first seven years exceed the net level premiums that would have fully paid up the policy in seven level annual payments. A policy that fails is a MEC. A material change, such as increasing the death benefit, can start a new test period.

Secondary sources, including insurer and actuarial publications, describe the consequences as follows. Confirm them with a tax professional.

• Loans and withdrawals from a MEC are generally taxed on a gain-first basis rather than basis-first.
• Policy loans from a MEC are generally treated as distributions.
• Taxable distributions before age 59 and a half may face an additional 10 percent tax, with some exceptions.
• Once a policy is a MEC, it generally stays one.
• Death benefits from a MEC are still generally income tax-free to beneficiaries; see are life insurance payouts taxable?.

Insurers typically monitor the test and send warnings before a payment would cause a policy to become a MEC. If you plan to pay large lump sums into a policy, ask about this first.

Section 1035 exchanges

Section 1035 of the Internal Revenue Code lets you exchange certain contracts for others without recognizing gain at the time of the exchange. In general, a life insurance policy can be exchanged for another life policy, an annuity or a qualified long-term care contract, but an annuity cannot be exchanged for a life policy tax-free. The original cost basis carries over, so the gain is deferred rather than erased.

• The exchange is generally done directly between insurers. Taking the money yourself and then buying a new policy is usually a taxable surrender.
• The old policy's surrender charges may still apply, and the new contract may start new charges, a new contestability period and different costs.
• Health or age changes could affect your rates on the new policy.

Questions to ask before you act

1. What is the current cash value, and what is the cash surrender value?
2. How would a loan or withdrawal change my death benefit?
3. Is the policy a MEC, or could this action make it one?
4. What is my cost basis, and what taxes might apply?
5. Could the policy lapse if the loan and interest grow?
6. Are there non-forfeiture options that fit better than surrender?

If you only need protection for a limited time, a convertible term policy may be an alternative route to permanent coverage later; see convertible term life insurance.

Frequently asked questions

Is a life insurance loan taxable?

Generally not for a policy that is not a MEC, as long as the policy stays in force. If the policy lapses or is surrendered with an outstanding loan, part of it may become taxable. Loans from a MEC are treated as distributions. Ask a tax professional.

How long does cash value take to build?

It depends on the policy. Cash value usually grows slowly in the early years because premiums cover costs. Ask for a year-by-year illustration.

Do my beneficiaries get the cash value when I die?

Usually they receive the death benefit, not the cash value on top of it, although some whole life policies pay both. Unpaid loans are subtracted.

What is a surrender charge?

A fee deducted if you cancel the policy, or withdraw too much, in the early years. The schedule is in your policy.

What is a 1035 exchange?

A tax-deferred exchange of one qualifying insurance or annuity contract for another. It must generally be done directly between insurers and can still involve surrender charges and new terms.

Does term life insurance have cash value?

Generally no. Term insurance covers a set period without a savings component.

Sources

• NAIC – Life Insurance (Insurance Topics)
• NAIC – Life Insurance (Consumer guide)
• Cornell Law School LII – 26 U.S. Code § 7702A (Modified endowment contract)
• Cornell Law School LII – 26 U.S. Code § 1035 (Certain exchanges of insurance policies)
• Cornell Law School LII – 26 U.S. Code § 101 (Certain death benefits)