Should I Cash in my Whole Life Policy?

Choosing to cash in your whole life policy can be a complex decision that requires some careful consideration.  There are a few consequences to such a decision that you should understand prior to deciding whether or not you actually cash it in.  There are also other options you most likely have at your disposal that may be more beneficial to you than a full surrender of your whole life policy.

What Happens when you Surrender a Whole Life Policy?

Surrendering a whole life policy means you cancel the entire policy.  Doing this ends your death benefit coverage–as well as any other features you might have attached to your whole life policy like a child or spousal term rider.  If your whole life policy has cash value when you surrender it, you will receive this cash value from the insurance company.

You may also forfeit any dividend owed to you at the end of the policy year if you surrender your policy.  Some companies will pay a pro-rated dividend that represents the number of months you held the policy during the policy year.  For example, let's say that if you keep your policy you will receive a $1,200 dividend at the end of the policy year.  You however decide to cancel your policy three months into the policy year.  The insurance company might have a policy that pays you a $300 dividend for the three months of the policy year that you had your policy in force.

There are no comprehensive rules that govern what an insurer must do regarding the dividend payment when a policyholder surrenders a whole life policy mid year.  The payment of a dividend is generally up to company discretion.

How to Cash in Your Policy

If you decide that you no longer want/need your whole life policy and you'd like to surrender it, you begin the process by contacting the insurance company or your agent and requesting a full policy surrender.  The insurance company will need to generate the necessary paperwork for the cancelation.

Once prepared, you'll receive the paperwork either through mail or electronic transmission (usually email if electronic).  You'll need to complete the paperwork, sign it, and send it back to the company or your agent.

Once the insurance company receives the signed and completed paperwork, it will process the request, cancel the policy, and send you a check for the cash value balance of the whole life policy.  Processing time is generally around a month.

Tax Consequences when Surrendering your Whole Life Policy

If you receive more in cash value from the policy surrender than you paid in premiums, you will owe ordinary income taxes on the difference.  This difference is taxed as a gain created by the policy.  You should also understand that any dividends taken as cash while the policy was in force and/or any withdrawals made from the policy's cash value will deduct from the premiums you paid. This might effect the taxes owed upon policy surrender.  Also, loans taken against the policy cash value may cause taxable income that is higher than you originally assumed.  Let's look at some examples to better understand this.

Dividend Example

Assume that Susan has a whole life policy with $100,000 in cash value.  She paid $80,000 in premiums to date on the policy.  She also received a total of $10,000 in dividends paid to her in cash throughout the life of the policy.  She decides to surrender her policy.  The insurance company must reduce the $10,000 in dividends paid to Susan from her premiums paid (also known as her cost basis) and report $30,000 of taxable income paid to her by the surrender of her whole life policy.  Susan will receive a 1099 from the insurance company that shows she received $100,000 of cash and $30,000 of it is taxable income.

Withdrawal Example

Mike has a whole life policy with $100,000 in cash value.  He paid $80,000 in premiums to date on the policy.  He also took a withdrawal from the policy a few years ago for $15,000.  He decides to surrender his policy.  The insurance company must reduce Mike's cost basis by his $15,000 withdrawal and report $35,000 from the surrender as taxable income paid to him by the surrender of his whole life policy.  Mike will receive a 1099 from the insurance company that shows he received $100,000 of cash and $35,000 of it was taxable income.

If there is no gain in the policy (i.e. the policyholder paid more in premiums than he/she has in cash value) then there are no taxes due upon surrendering the policy.  While you may view this scenario as a loss, it does not count as an investment loss and you cannot use it as a tax deduction.  You simply walk away from the insurance policy with less money than you put into it.

You might also receive a 1099 reporting interest income when surrendering a whole life policy.  This happens when a life insurer delays the payment of the cash value owed to the former policyholder.  Life insurers cannot hold cash values due to policyholders of surrendered policies indefinitely.  As a motivation to process requests quickly, some states have laws that compel insurers to compensate policyholders when the insurance company fails to process the surrender request within a certain time frame.  This compensation comes in the form of interest paid on the cash value while the insurance company has it.  If this happens to you when surrendering a policy, you will receive a 1099 reporting interest income as a result of the interest payment.

This is generally a small interest payment, but it is reportable and taxable income to you and it is a source of confusion for a great many deal of former policyholders when the choose to cancel a policy.

Loan Example

Gwen has a whole life policy with $100,000 of cash surrender value.  To date, she paid $90,000 in premiums.  She also took a $20,000 loan from the policy a few years ago and let interest accumulate on the balance of the loan.  To date, the loan balance is $30,000.  Gwen decides to surrender her whole life policy.

You might assume that Gwen's taxable income created by the policy cancelation is $10,000 because she will receive $100,000 from the surrender and she paid $90,000 in premiums.  But unfortunately, you'd be wrong.

The surrender will actually release $130,000 of cash value, but $30,000 of that cash value will repay the outstanding loan Gwen has.  Though Gwen will not receive this $30,000, tax law in the United States says it still exists and counts towards her gain in the policy.  So Gwen will receive a 1099 from the insurance company showing a $130,000 distribution to her of which $40,000 is taxable.

Keep in mind that while Gwen did not receive the $30,000 at policy termination, she did effectively take the money out in prior years and never paid taxes on it because of the tax favorable feature of life insurance policy loans.

Will you Lose Money if you Cancel your Life Insurance Policy?

Generally speaking, there is no fee or penalty assessed when someone surrenders a whole life policy.  Whole life insurance does not generally have surrender charges, nor are there any additional adjustments (such as Market Value Adjustments) made to a whole life policy.

The only thing you stand to lose when surrendering a whole life policy is your death benefit and (potentially) any dividend due at the end of the policy year.

Of course, if you surrender a policy when you have less cash value than you paid in premiums, you effectively lose money upon canceling the policy.

When Should you Cancel your Whole Life Policy?

If you reach a point in your life where you believe you no longer need the death benefit offered by your whole life policy, and you do not want to pay any further premiums, it might make sense to surrender the policy and take the cash value to do other things with the money.

Most people experience changes throughout their lives and what made sense in earlier years may no longer.  But since a policy surrender is an irrevocable decision, there are a few things you might want to consider before you pull the trigger on policy termination.

If you are experiencing circumstances that make paying the premium difficult, you have options you can use to cover the premium–at least in the short term–that will preserve the majority of your outstanding death benefit.

You can use a loan from your policy to pay the premium.

You can withdraw cash value from your policy to pay premiums.

You can use dividends to pay all or part of the premium due.

If you believe that you will never regain your ability to pay the premium, you could exercise a non-forfeiture benefit to keep all of your current death benefit in place as term life insurance with no premium for a specified period of time, or you can take the reduce paid-up option to keep a smaller whole life death benefit in force permanently with no future premiums due.

Lastly, you should also know that you can use options mentioned above (like the reduce paid-up option or dividends to pay premiums) to keep your policy, but stop paying premiums.  You may want the death benefit of the whole life policy.  Or you may want the rate of return on cash value it continues to produce.  You simply want to put the money you have to pay in premiums to other use.  The reduce paid-up option and/or the option to use dividends to pay premiums could be an excellent way to stop premiums but keep your policy.

If you don't want to keep the death benefit or continue to benefit from the accumulation of cash values inside the policy, then it may be time to cancel the policy.  Just make sure you are aware of the consequences outlined above before you make this move.


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