Is There a Penalty for Cashing out Your Life Insurance Policy?

For millions of Americans who own a life insurance policy, letting it “lapse,” or missing a premium payment, means voiding the protection and security gained when you held the policy. Imagine paying into an asset for several years, only to be left with nothing of value if a policy lapses or is no longer worth keeping. There is a solution, however. You can cash out your life insurance policy through what is known as a life settlement.

What is a Life Settlement?

A life settlement is defined as the sale of an existing life insurance policy for more than its cash surrender value, but less than its net death benefit. There are many reasons why people may want to sell their life insurance policy, including:

  • Mounting medical bills
  • The policy owner wants to invest in long-term care
  • The premium is no longer affordable
  • The policy no long meets the policyholder’s estate plan goals
  • The policyholder no longer has dependents who are reliant on their income

These are just a few reasons why people sell their life insurance policies, but there can of course be many other reasons behind the decision. 

Is There a Penalty for Cashing Out My Policy?

If you are selling your policy at age 59.5 or before, you will incur a 10% penalty. Other than that, there are no penalties for selling your policy. There are, however, tax rules to keep in mind. Life settlements are taxed in three ways:

  • Money received from a life settlement up to the tax basis is free of income tax.
  • Money received that is greater than the tax basis, but less than the cash surrender value, is taxed at ordinary income rates.
  • Money received that exceeds the cash value of your policy is taxed as capital gain.

The amount of taxable income is calculated by subtracting the total amount you have paid in premiums, your tax basis, from the settlement amount. The IRS provides additional information on how life insurance proceeds are taxed. 

How can I sell my policy?

Life insurance policy payouts are issued to the beneficiary within a few days or weeks or receiving a completed claim form, assuming there are no delays related to life insurance fraud investigations. Once the claim is approved by the insurance company, beneficiaries must choose how they will receive the funds. The following options are usually presented:

  • Lump sum: A lump sum payout is the most popular choice but there can be drawbacks. For one, receiving such a large amount of money at once can be overwhelming for some, plus the FDIC insures only up to $250,000 bank balances per depositor. This payout choice may be best for clients with multiple bank accounts to spread out the payout if the amount is more than $250,000.
  • Retained asset account: Some beneficiaries have the option of leaving the payout with the life insurance company, though the interest rate could be smaller than alternative depository institutions and interest income will be taxed. Clients who don’t want to be bothered with FDIC insurance limits associated with traditional banks may opt for this route as the insurance company will protect the entire payout amount.
  • Convert to an annuity: Converting the proceeds from a death benefit to an annuity for a payout that lasts a lifetime can help control the amount of money a beneficiary has access to at one time, as opposed to a lump sum. However, the younger the beneficiary, the smaller the payout amount since they will be distributed over a longer period of time. This option may be more appealing to clients within retirement age as it offers a guaranteed source of income without risk of losing money that can be inherent in other investment vehicles, such as the stock market.
  • Fixed amount: Also known as specific income payout, beneficiaries can choose to receive a set amount each month or year over a selected period of time. Once the funds are depleted, payments cease. This option, like the retained asset account option, avoids the burden and risks associated with a lump sum payout. Keep in mind that any interest your client earns is taxable.
  • Life income with period certain: This option allows your client to ensure payments are made even if they die. For instance, if the individual dies in the fourth year of a 10-year period certain, the beneficiaries they have listed will receive the payments for the remaining six years of that 10-year term. This option may suit clients older in age with beneficiaries in need. 
  • Life settlement: A policyholder can choose to sell their policy during their lifetime. Policyholders will receive a lump sum that is more than the policy’s cash surrender value, but less than its net death benefit. Life settlements are great for people who want cash now but might be unattractive for clients who want to maximize the death benefits payout to beneficiaries.

To find out if a life settlement is the right option for you, it’s important to seek professional advice. The first step is to see if you qualify for a life settlement. This can be done by filling out a simple online calculator or calling a life settlement specialist