Life Insurance and Can You Cash it in + Cash Surrender Value

Can You Cash in a Life Insurance Policy?

Yes, generally a whole life insurance policy holder can withdraw cash up to the policy basis (cash premiums paid into the policy less any fees or expenses). Further, a cash withdrawal up to the policy basis usually suffers no tax consequences because proceeds from life insurance policies are not taxable generally.  

What is Cash Surrender Value?

When you own an insurance policy, you purchased it with the intent of controlling risk and transferring it to another party in exchange for premium payments.  However, you may have liquidity needs and might consider voluntarily terminating your whole life insurance policy before its maturity or an insured event occurs.

When you elect to surrender your whole life insurance policy, you turn in your policy in exchange for a discounted payout, otherwise known as the cash surrender value.  By definition, the cash surrender value represents the sum of money an insurer pays to the policyholder or an annuity contract holder when surrendering the life insurance policy.  In the case of life insurance, this amount calculates as a discounted payout from the full value of the death benefit.

In practice, the cash surrender value asymptotically approaches the expected payout value as the policyholder holds the policy in good standing (all premiums paid on a timely basis).  In other words, as more time passes and the insured event nears, the insurer will assess a lower percentage in surrender charges.

The insurer calculates the cash surrender value by taking the full cash value payout and deducts the surrender charges, plus any unpaid loan principal or interest on the policy.

How do Premium Payments Affect the Cash Surrender Value?

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The insurer bases the cash surrender value of the policy on the total premiums paid up to the termination date.  Therefore, as the insuree pays premiums, the cash surrender value of the policy will grow.

Because whole life insurance policies allow policyholders to pay off premiums far in advance of receiving the death benefit, the policies can eventually pay dividends from the policy’s underlying investments.

These policies allow older policyholders to maintain their coverage after retirement and also receive tax free income in the form of policy dividends.  However, these dividend payments represent part of the policy’s cash value and can instead pay premiums due.

In the early portion of a whole life insurance policy, the saving portion for the underlying investments appear minimal in comparison to the premiums paid.  The cash surrender value will be less than the actual cash value of the policy.

What is a Death Benefit?

In life insurance, when the insured party passes away, the insurance policy pays out a death benefit.  The death benefit represents the amount paid to the beneficiary based on the stipulated terms of the insured’s life insurance contract.  In practice, when the insured’s covered death occurs, the death benefit transfers to the policy beneficiary.

Alternatively, a death benefit in a life insurance policy also accrues when an annuity or pension-holder dies and payments still remain on these financial instruments.  Said simply, the payment stream received from the annuity or pension-holder’s account will continue (albeit at a reduced rate) to pay after the death of the primary individual. 

How Do I Calculate the Cash Surrender Value of an Insurance Policy?

When calculating the cash surrender value of an insurance policy, the following rule of thumb applies:

The longer a policyholder maintains a policy in good standing, the lower the percentage the insurance company will charge in surrender charges.

With this serving as a baseline, from here, to calculate the cash surrender value, you must identify the full cash value paid as a death benefit and deduct the applicable surrender charges.  Additionally, you must deduct any unpaid principal or interest on loans taken against the policy.

What are the Tax Consequences of Surrendering a Life Insurance Policy?

By surrendering your life insurance policy, you will not lose the tax free status of the life insurance proceeds. You will realize less in return because the cash surrender value represents a lower payout than the full death benefit or payment stream you would normally receive.

However, one silver lining comes from the IRS not assessing any taxes on the cash value of a policy when you withdraw money up to your cost basis.  In other words, this money also avoids taxation.

As another benefit, on loans taken against your life insurance policy, the IRS will not levy taxes on these funds either as they do not constitute taxable income.  One item to pay attention to, however, occurs in the event your policy lapses.  

In this circumstance, the IRS will compel you to pay income tax on your entire gain related to the life insurance policy.

Are Life Insurance Proceeds Taxable?

man looking at financial statement

For all life insurance policies meeting the definition of life insurance, any cash surrender value increases for the policy would not have a taxable impact until received.  Further, the death proceeds would avoid taxation.  

Said succinctly, in most circumstances life insurance proceeds (or, the death benefit) do not have taxes paid against the proceeds received.

In the event the insured carries a life insurance policy which pays cash dividends (e.g., whole life insurance), these dividends do not count as income on a taxpayer’s return.  This passive income receives favorable tax treatment so long as the amount received does not exceed the net premiums paid on the policy.

What is the Difference Between Cash Value vs. Cash Surrender Value of Life Insurance?

These two items represent different elements of the life insurance policy.  The cash value of the policy represents its accrued value. Some of the factors which affect how to calculate the cash value include:

  • Face value of the life insurance policy
  • Premium payment term
  • Duration contract has been held

To summarize, as the policyholder continues paying premiums on time and the funds held in investments underlying the life insurance policy increase in value, so too will the cash value.

On the other hand, the cash surrender value represents the discounted payout the insuree would receive when opting to withdraw any funds up to the basis of the policy.

Is Cash Surrender Value of Life Insurance a Current Asset on the Balance Sheet?

Tax rules and standards govern numerous accounting transactions and treatment.  From an accounting perspective, because the cash surrender value of a life insurance policy represents an asset you can control, accounting standards recognize it as an asset on the balance sheet.

On the other hand, a future death benefit the company may or may not receive represents an economic benefit, and not one the company can control.  As a result, the discounted present value of a death benefit should not reside on a company’s balance sheet.

Additionally, the company must understand the type of life insurance policy.  Generally, if the life insurance policy has a cash surrender value, this value should appear on the balance sheet.  Any cash outflow which occurs above the annual increase in cash surrender value should have the company expense it and reflect this transaction on the income statement.

Term life insurance does not contain a cash surrender value (because no investments underlie the policy’s death benefit with which the insuree holds a claim), whereas universal life and whole life insurance policies do.

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