Permanent life insurance policies earn a cash value over time. If the policyholder decides to cancel the coverage, the insurance company must pay all or a portion of the cash value to the policyholder—this amount is called the “cash surrender value.”
If your permanent life insurance policy has built up significant cash value, or if funds are tight, you might be considering canceling the policy to access the funds. But before you do, it’s important to understand what you’ll give up and if your cash value will be subject to “surrender penalties” and taxes.
If you need cash to get you through an emergency, or can’t afford premium payments, there are alternatives to canceling a policy that may provide the funds or breathing room you need, while keeping your coverage in place.
Definition and Examples of Cash Surrender Value
In order to better understand “cash surrender value,” you first need to know what “cash value” is and what surrender charges are.
Life insurance policies fall into two broad categories, term life and permanent life. Term life policies last for a limited number of years, such as 20, and only pay a death benefit if the insured dies within that time. But permanent life insurance is designed to last your entire life and builds a cash value within the policy in order to do so. This cash value can also function as a kind of savings vehicle.
The cash value is not the same as the amount of coverage you have, or the death benefit of the policy. It’s a cash account internal to the policy that’s designed to offset the increasing cost of that coverage as you age.
Permanent policies have a “surrender period” that may last for 10 years or more. During this time, the insurer will assess a penalty if you decide to surrender (cancel) the policy according to a surrender fee schedule listed in the policy.
The “cash surrender value” in a permanent life insurance policy is the cash value minus any applicable surrender charge.
How Is Cash Surrender Value Calculated?
The surrender value of your policy depends on how much cash value you have and what if any surrender penalty exists when you want to cancel it. How long the surrender period lasts and how surrender charges are calculated is listed in your policy; they’re based on your age, gender, rating class, and the amount of coverage you have.
The penalty may be based on a percentage, and typically decreases every year until the policy is “out of surrender,” and it reaches zero. During the first few years of the contract, surrender charges can be especially steep. For example, during the first policy year, your surrender value could be 0% of the cash value, if you have any cash value built up. But in the fifth year, it could be closer to 80% of the cash value amount. It depends on the specifics of your policy and is not necessarily a straightforward calculation.
If you want to cancel a policy during the surrender period, ask your insurer what the cash surrender value is to know how big of a hit you’ll take in surrender fees—it may be worth waiting until the policy is out or almost out of the surrender period, or accessing the cash value via a loan or direct withdrawal.
A policy’s cash surrender value isn’t fixed; it usually increases over time as the policy’s cash value grows and the surrender charges decrease.
Tax and Other Implications
When cashing out a life insurance policy, the IRS may consider a portion of the money as taxable income. To calculate the amount of taxable income, subtract the total amount you paid in premiums from the amount of money you received in the cash surrender. For instance, if you receive a cash surrender payment of $50,000 and paid $40,000 in premium payments, $10,000 would be subject to taxation.
Aside from potential taxation, it’s essential to understand that cashing out your policy cancels it. Once you surrender your policy, you can not change your mind, and there is no grace period during which you’ll have coverage. Beneficiaries will receive no death benefit from the policy, and it may be difficult or even impossible for you to get a new life insurance policy, depending on your age and health.
The premium on your existing policy is based on your age and health when you applied for it. If you wish to replace it with a comparable policy any time in the future, the cost will be much higher, or you might be uninsurable, especially if you’ve developed health issues.
How Does Cash Surrender Value Work?
People surrender their life insurance policies for numerous reasons. Often, they cancel because they no longer need the coverage.
If you’re the owner, surrendering your policy usually requires that you simply fill out a “surrender request” form and submit it to your insurer. Once you submit the form, you can expect to receive a check from the insurance company.
You can also request a partial surrender or cash withdrawal, or take out a loan against the cash value, instead of surrendering the entire policy. Talk to your insurer about how these might affect your policy.
Alternatives to Surrendering Your Policy
If you still need life insurance, it’s wise to continue coverage rather than cancel it. And there are ways you can access the cash value in your policy while keeping your coverage intact.
- Use the cash value to pay premiums: If you’re having difficulty paying premiums, your policy might have a provision to deduct premiums from your cash value when payments aren’t made. Alternatively, you may be able to select a “reduced paid-up” option, which exchanges your policy’s cash value for a smaller death benefit, but requires no additional payments from you.
- Make a withdrawal: You can withdraw from your life insurance policy’s cash value instead of cashing out the entire amount. If the amount you withdraw is less than the amount you’ve paid in premiums, you shouldn’t have to pay any income tax.
- Take out a loan against the cash value: If your policy is in its surrender period, consider taking out a loan against its cash value. You must repay the loan, with interest, or risk reducing your death benefit. But you won’t be assessed surrender fees.
- Exchange your policy: If you need long-term care insurance or would prefer to own an annuity, you can exchange your life insurance policy for either without having to pay taxes on any gains via a 1035 exchange.
- Make use of an accelerated death benefit (ADB) provision: If your policy includes an ADB provision, you may be able to access a portion of the death benefit “early” if you have a chronic or terminal illness or require long-term care.
- Sell your policy: If you’re over 65 or terminally ill, you might want to sell your policy in a life or a viatical settlement, and potentially receive more than the cash value. When you sell a policy, the settlement company becomes the owner and beneficiary, paying any subsequent premiums and receiving the benefit when you die.
If you sell your policy to a settlement company when you’re terminally ill, you shouldn’t have to pay tax on any gains.
Talk to your insurer before surrendering your policy or taking any significant action on it. An agent can provide the exact cash surrender value as well as information and illustrations that show how long your policy can survive if you stop paying premiums or make a withdrawal. They can also discuss the implications of taking out a loan or if your policy has an ADB provision that you can use.
- The cash surrender value is the amount of money an insurer will pay you if you surrender a permanent life insurance policy that has a cash value.
- Typically, the amount of cash surrender value increases as the policy’s cash value increases and the surrender period decreases.
- Surrendering a policy cancels your coverage.
- If the cash surrender value of your policy is higher than the amount you’ve paid in premiums, when you cancel the coverage, you’ll have to pay taxes on the earnings.
- If you still need coverage, you have options for accessing the cash in your policy without canceling it.