Surrendering a life insurance policy is a major financial decision that can bring immediate access to cash, but may also come with significant consequences. When you surrender your policy, you give up coverage in exchange for its cash value… but are there better options out there for you? It’s important to understand how the surrender process works, what it means for your beneficiaries, and whether there are better financial options available.
Key Takeaways
- What happens when you surrender your life insurance policy? When a life insurance policy is surrendered for its cash value, the policy is terminated, and the policyowner receives a lump sum payment based on the policy’s accumulated cash value.
- What is the cash surrender value of a policy? The cash surrender value is the amount the insurer pays out, which is calculated after deducting surrender fees and any outstanding loans from the policy.
- Are there any tax implications when surrendering a life insurance policy? Any amount received above the total premiums paid into the policy may be subject to taxes as ordinary income.
Understanding a Policy Surrender
Choosing to surrender a life insurance policy is not always easy. Many policyowners are driven by financial needs or a change in long-term planning. While surrendering provides access to funds, it also eliminates the policy’s death benefit and any future financial support the policy could offer loved ones.
Who Are Policyowners?
Policyowners are the individuals who own and control a life insurance policy. They have the right to make changes to the policy, including naming beneficiaries, taking out loans, and ultimately deciding whether to keep or surrender it. Life changes such as retirement, unexpected medical expenses, or reduced income can cause policyowners to reconsider the value of keeping a policy. For some, surrendering the policy may appear to be the simplest way to tap into accumulated cash.
Exploring Cash Surrender Value
The cash surrender value is the amount of money a policyowner receives when they decide to terminate their policy. This value grows over time and depends on several factors, including the type of policy, how long it has been active, and how much has been paid in premiums. Insurance companies also deduct any fees if the policy is surrendered early, and if the policyowner has taken out loans against the policy, those amounts will be subtracted as well. As a result, the actual payout is often lower than expected.
Impact on Beneficiaries
When a policy is surrendered, the death benefit is canceled. This means that the beneficiaries named in the policy will no longer receive any payout when the insured person passes away. For families who rely on that future financial security, this can have a lasting impact. It is essential to consider how this decision will affect loved ones before surrendering a policy.
Financial and Tax Considerations
Before surrendering a life insurance policy, it is important to consider how it will affect your finances and taxes. While the payout may be helpful in the short term, it can lead to financial losses and unexpected tax obligations.
Financial Impacts of Policy Surrender
One of the most important things to understand is that the cash surrender value is generally less than the total premiums paid into the policy. This is especially true in the early years of a policy when surrender fees are highest. In addition, if the policyowner has taken out loans or missed premium payments, those amounts are deducted from the final payout. This means the amount received may be far lower than what the policyowner originally invested.
Understanding Tax Implications
There may be tax consequences when surrendering a life insurance policy. If the cash surrender value exceeds the amount paid in premiums, the difference is typically considered taxable income.
For example, if you paid $20,000 into your policy over time and receive $30,000 when surrendering it, the $10,000 gain is taxable as ordinary income. This can result in a higher tax bill and should be factored into your decision.
Consulting a Financial Advisor
Given the potential financial and tax implications, it is always wise to consult a financial advisor before surrendering a policy. A licensed advisor can help you understand how the surrender will impact your taxes, your overall financial health, and whether there may be better alternatives available.
Alternatives to Policy Surrender
Surrendering a life insurance policy is not the only option for accessing its value. In many cases, alternatives like life settlements or viatical settlements can oftentimes offer a better return on your years-long investment.
Considering Life Settlements
Explain life settlements as an alternative, highlighting how they can offer higher returns compared to traditional cash surrender, especially for high-value policies.
A life settlement involves selling your life insurance policy to a third-party buyer for a one-time, lump-sum payment. This option can be especially beneficial for folks over the age of 65 with high-value policies who no longer need or want the coverage. The payout from a life settlement is often significantly higher than the cash surrender value. In fact, on average, a life settlement payout can be four times the cash surrender value, making it a higher return on your life insurance investment.
Exploring Viatical Settlements
Similar to life settlements, viatical settlements occur when you sell your life insurance policy to a third-party buyer, but this transaction is designed for policyowners who are facing a terminal illness. These settlements allow individuals to sell their policy for cash while they are still alive, helping to cover medical bills and other urgent expenses. Eligibility for viatical settlements differs from a typical life settlement. Typically, a person with a critical or terminal diagnosis who has a life expectancy of two years or less can qualify for a vitaitcal settlement, no matter what age they are.
Other Policy Settlement Options
In some cases, policyowners may have the option to convert their life insurance to a reduced coverage plan. This allows the policyowner to receive a partial payout while keeping some level of coverage in place without needing to pay additional premiums. While this option is limited to certain types of insurance — usually permanent life insurance, not term life insurance — it offers flexibility for those who still want to maintain some death benefit protection.
Similarly, a retained death benefit in a life settlement allows a policyowner to sell their life insurance policy to a third-party buyer and retain a portion of the death benefit for their beneficiaries. The death benefit amount reserved for the beneficiaries is typically taken from the proceeds of the life settlement sale, making the overall offer less than it would have been without the retained death benefit. However, the policyowner rids themselves of any future premium payments, receives a lump-sum cash payment to use as they wish, and their beneficiaries still receive a portion of the original death benefit amount.
Common Motivations for Policy Surrender
Understanding why people choose to surrender their life insurance policies can help clarify whether it is the right move. Financial needs, changing family situations, and investment goals all play a role in the decision-making process.
Learn more about the process and alternatives in Ovid’s detailed overview of the life settlement process.
Changes in Financial Circumstances
When financial circumstances change, many policyowners find it difficult to keep up with premium payments. Job loss, rising healthcare costs, or other unexpected expenses can make it necessary to convert assets like life insurance into usable funds. Surrendering the policy provides immediate access to cash, though sometimes at the expense of long-term financial planning.
Alterations in Family and Estate Planning
Life events such as divorce, the death of a beneficiary, or a shift in estate planning goals may prompt policyowners to surrender their policies. If the original reason for purchasing the policy no longer applies, it might make sense to reallocate those funds elsewhere. This can lead to more flexible planning that better reflects current family dynamics.
Pursuing Better Investment Opportunities
Some policyowners decide to surrender their policies because they find better investment opportunities that offer stronger returns. While life insurance is a valuable financial tool, other options such as real estate or retirement accounts may better align with current financial goals. Accessing the cash value in the policy can provide the capital needed to pursue these alternatives.
Conclusion and Final Thoughts
Surrendering a life insurance policy for its cash value is a decision that carries long-term financial implications. While it may provide quick access to funds, it also means giving up future benefits that could support your loved ones. Before making a final decision, consider all the financial and tax consequences, and explore potential alternatives like life settlements or viatical settlements.
At Ovid, we are here to help you understand your options and make informed choices. If you are considering surrendering your policy, take the first step by connecting with a trusted provider through our simple process. Get started today to explore your options and discover the best path forward for your financial future.
