Permanent life insurance policies that accumulate cash value are meant to be, well, permanent. But sometimes financial priorities change, budgets shift or income fluctuates to a point that you may decide your insurance policy is a financial tool you no longer need. Fortunately, unlike most term life insurance policies, which have no cash surrender value, surrendering a permanent life insurance policy doesn’t have to result in a total loss.
Cash Value vs. Cash Surrender Value of Life Insurance
In order to understand the cash surrender value of life insurance and how to calculate it, first it’s important to know what cash value is and how it works.
When you pay your premium on a permanent life insurance policy, a portion goes toward the policy’s death benefit and administrative costs. The rest goes into a built-in savings account called cash value. Depending on the type of permanent insurance, this cash value may earn a guaranteed rate of return (whole life insurance) or a return based on indexes, stocks or bonds (universal or variable life insurance). Whole life insurance policies from mutual insurance companies may also earn dividends.
While your policy is active, you can withdraw cash value or you can borrow it in the form of a policy loan. Any amount you withdraw above your basis (the amount you’ve paid in premiums) will be taxed, but policy loans aren’t taxable unless your policy lapses with unpaid loans. If you pass away with outstanding loans, they will be deducted from the policy’s death benefit, plus interest.
The cash value inside a life insurance policy reflects the amount of death benefit you are able to access as a living benefit. It shouldn’t exceed the amount of the death benefit. (If it does, the policy would be considered a modified endowment contract, or MEC, and lose its tax-advantaged status.) In other words, cash value and death benefit are not two separate accounts; cash value is a representation of your investment in the policy. In rare cases, your beneficiary may be eligible to receive some cash value in addition to a death benefit—typically with the purchase of additional policy riders.
Cash Surrender Value
If you decide you no longer want your permanent life insurance policy, your insurance company will pay you a lump sum when the policy voluntarily terminates. This is called the cash surrender value. Sometimes the cash surrender value is equal to the cash value of your insurance policy, but there are instances where it may be less than your accumulated cash value.
During the early years of a policy, returns on cash value are minimal compared to the amount of premiums paid, and insurance companies may charge additional fees for early surrender. These fees usually apply in the first 7 to 10 years a policy is in force, with penalties for early surrender decreasing each subsequent year. Age, gender, coverage amount and rating class may also play a factor.
Once your policy has matured beyond the surrender period, the cash surrender value of life insurance is equal to the cash value of your policy—but not equal to the face value of the policy (the death benefit). Any portion of cash surrender value that comes from cash value growth (like from a guaranteed rate of return, dividends, or growth from indexes, stocks, or bonds) may be taxable. You can calculate this amount by subtracting premiums paid from the cash surrender value. For example, if you’ve paid $80,000 in premiums and your cash surrender value is $100,000 you may be taxed on gains of $20,000.
Alternatives to Surrendering a Life Insurance Policy
Surrendering a life insurance policy is a permanent transaction. Some types of life insurance allow you to surrender a portion of your policy, similar to a withdrawal of cash value; this lowers the death benefit of the policy and may have tax implications. A complete surrender means you no longer have life insurance coverage—your beneficiaries will not be eligible for any benefit. Depending on your age and health, purchasing life insurance after you’ve surrendered a policy may be prohibitively expensive, or you may no longer be eligible for life insurance at all.
If your financial situation has changed, there are alternatives worth considering before you surrender your policy:
The cash value inside a life insurance policy can function as a financial foundation for emergencies or temporary financial setbacks. On the other end of the spectrum, its liquidity is ideal for use in investment opportunities or to generate business capital. You can even use policy loans to pay your insurance premiums.
Rather than surrendering a policy, utilizing a policy loan for temporary cash flow still provides insurance coverage. Plus, with certain whole life insurance policies, you continue to earn a guaranteed rate of return on the full value of the policy.
Whole life insurance policies from mutual insurance companies are eligible to earn non-guaranteed dividends. The top mutual insurance companies we work with at Paradigm Life have historically paid out dividends for over 100 years. Some policyholders receive dividends in a check, while others utilize dividends to buy additional insurance, but they can also be used to pay insurance premiums.
If your current life insurance policy is underperforming or your premiums have become too expensive, you may be able to utilize a 1035 exchange, which allows you to transfer some or all of your cash value and put it toward a new policy without tax implications. Examples include transferring a universal life insurance policy to a whole life insurance policy or transferring a life insurance policy to an annuity.
When you purchase life insurance, you often have the option of adding on various types of supplemental insurance. Called policy riders, this additional insurance customizes your policy to your needs and gives you options, like accessing a portion of your death benefit tax-free while you’re still living if you become disabled, terminally or chronically ill, or need long-term care.
If you’re over 65 and no longer need life insurance, it may be more profitable to sell your insurance policy in a life settlement than to trade it in for cash surrender value. With a life settlement, a third party purchases your policy, becoming both the new owner and the new beneficiary. The third party assumes your premium payments and gets the death benefit payout when you die. The amount your policy sells for depends on the face value of your policy and the cost of insurance premiums. Your cash value, policy riders, and any outstanding policy loans may also play a role. There may be tax implications on capital gains with a life settlement.
Similar to a life settlement, a viatical settlement may be more profitable than the cash surrender value of life insurance. Viatical settlements are for people who are terminally ill. With a viatical settlement, a third party purchases your policy and becomes both the new owner and beneficiary. The third party assumes your premium payments and gets the death benefit payout when you die. The amount your policy sells for depends on the face value of your policy and the cost of insurance premiums. Your cash value, policy riders, and any outstanding policy loans may also play a role. There typically are not any tax implications on capital gains with a viatical settlement.
How to Surrender Your Life Insurance Policy
If you’ve considered all the alternatives and are still leaning toward surrendering your life insurance policy, be sure to speak to your insurance broker or a Wealth Strategist. At Paradigm Life, consultations with Wealth Strategists are always free and we’re happy to provide financial education—even if you’re not a current client.
Not only can an insurance broker or Wealth Strategist help you calculate the cash surrender value of your life insurance policy, they can also walk through your options and illustrate comparisons, ensuring your decision is the right choice financially.
For example, if your policy is subject to a surrender fee, it may be possible to structure withdrawals and/or policy loans to help float premium costs until such a time that the surrender fee no longer applies. Sometimes, policyholders don’t realize they’re receiving dividends that can be used to pay insurance premiums. Or maybe your policy has a rider that you could utilize to increase cash flow. Finally, perhaps you can use a 1035 exchange and make the switch from a costly, underperforming insurance policy to a policy with guaranteed returns or to an annuity.
If you and your insurance broker or Wealth Strategist ultimately decide that surrendering your policy is the best decision for you and your family, you’ll stop paying your premiums and contact your insurer to tell them you wish to terminate your insurance coverage. You’ll then fill out a surrender form provided by your insurer and send it to your insurance company. Be sure to follow up and make sure your form was received so you’re no longer liable for any premium payments (and they aren’t deducted from your cash surrender value). Your insurance broker or Wealth Strategist can help you with the procedure.
At Paradigm Life, our goal is to help you create a Perpetual Wealth Strategy with financial tools that make sense for your family, your budget, and your financial dreams. If you’re considering permanent life insurance but are unsure if it’s right for you, schedule a complimentary consultation today.