Life insurance is a vital part of any financial plan, but it won't serve the same role for everyone. Some investors only need coverage for a set time, and buy policies without cash values. Others treat cash values in their insurance as a carefully considered asset, and part of their long-term financial planning. Policies containing cash values can be cashed out at the owner's discretion, but it's not always worth doing.
Term vs. Permanent
Not all policies contain cash values. Term life insurance provides a death benefit for a specified length of time, but builds no value within the contract. The whole premium goes to cover the cost of insurance, and term coverage is correspondingly inexpensive for young purchasers. If older buyers still need coverage, the cost of term insurance can quickly become prohibitive. Permanent insurance policies provide coverage for the whole life of the insured person, at a premium that's higher when the insured is young, but lower in later years. Some of the premium in a permanent policy is invested, creating tax-sheltered growth within the policy.
As long as the policy has accumulated cash values, the owner can cash it out and retrieve that money. In practice, it takes several years for that to become an attractive option. Insurers usually charge stiff "surrender fees" during the policy's early years to ensure they recover their costs if the policy is canceled. Those fees often reduce or eliminate any advantage the owner gains from surrendering the policy. Surrender fees dwindle over time, as the company recovers the expenses of issuing the policy, so it costs less to surrender a policy that's been in force for several years.
If the policy has been in force long enough to accumulate a substantial amount of cash value, you'll pay taxes on part of the proceeds when you surrender the policy. The amount you paid in premiums is exempt, but remaining amounts are fully taxable. For example, if your policy held $153,000 in cash value, and you paid $100,000 in premiums, the $53,000 balance would be taxed. Surrendering the policy might also cause hardship to your beneficiaries in the event of your death if there isn't enough value left in your estate to meet their ongoing needs.
Most policies let you withdraw some or all of your cash value, at little or no cost. Again, the portion representing your premium payments is non-taxable, but the gains are taxed as ordinary income. You can also borrow from the policy, which doesn't trigger taxation. In both cases, your policy's death benefit remains in place, as long as you keep up the premium payments. If you've taken a loan, that amount and any interest will be deducted from the death benefit. It's also possible to sell your policy to a settlement company, which pays up-front cash and takes ownership of the policy. When you die, the company collects the death benefit.
Like any other financial decision, cashing in your life insurance requires some thought. If your family still needs the death benefit to ensure its future, or if it's needed to defray the costs of settling your estate, surrendering a policy should be your absolute last resort. If you're facing transient financial pressures, policy loans or withdrawals might be a better option. Some companies also offer payouts for specific types of hardship. Consider the ramifications carefully before you decide.
Fred Decker is a trained chef and certified food-safety trainer. Decker wrote for the Saint John, New Brunswick Telegraph-Journal, and has been published in Canada's Hospitality and Foodservice magazine. He's held positions selling computers, insurance and mutual funds, and was educated at Memorial University of Newfoundland and the Northern Alberta Institute of Technology.