Looking for a quick infusion of tax-free cash? Your life insurance policy may provide one. And you don’t have to die to collect.
Permanent vs. Term Life Insurance
To get money out of your life insurance policy without dying, you must have the right type of policy. Life insurance policies come in two basic types: permanent and term.
Term life insurance lasts only for a set number of years—typically, 10 to 30. If you die during the term, your beneficiaries get a death benefit. If you die after the term expires, your beneficiaries get nothing. You can’t get money from a term policy while you’re alive.
Permanent life insurance lasts for your whole life (so long as you pay the premiums). It pays a death benefit to your beneficiaries when you die.
Permanent policies also include a savings component. A portion of your premiums is placed into a cash value account, and this sum grows on a tax-deferred basis. Over time, the interest earned on the policy’s cash value can grow larger than the total amount of premiums you pay. Moreover, you can access your policy’s cash value while you’re alive.
Permanent policies come at a price. They cost much more than term life insurance—ten times as much, or even more. Nevertheless, permanent polices are a popular form of life insurance.
There are several types of permanent life insurance policies:
- Whole life. With these policies, you pay the same premium for life, and the cash value grows at a guaranteed, fixed interest rate set by the insurer.
- Universal life. With universal life, your premiums are flexible— you can accept less coverage for lower premiums.
- Variable life. These policies allow you to invest your cash value, usually in mutual funds. But they lack the premium flexibility of universal life polices.
- Variable universal life. These combine the benefits of universal life and variable life policies. Your premiums are flexible, and you can invest your cash value in stocks, bonds, mutual funds, and other assets. Your premiums can increase or decrease, depending on your investment returns.
- Indexed universal life. With these policies, the growth of your cash value is based on a stock market index, such as the S&P 500.
If you have one of these policies, it will have a cash value. You can usually find the amount on your life insurance statement.
There are several different ways to tap into your policy’s cash value while you’re still alive.
Partial Cash Withdrawal from Policy
You can withdraw a portion of your policy’s cash value without canceling your coverage.
You shouldn’t do this right away. Building cash value is like growing a savings account with small deposits over time. Typically, it will take several years— usually 10 to 15 years—for the cash value to grow enough to make tapping into it worthwhile.
Be sure to read your policy carefully to see how cash withdrawals are handled. Many insurers cap withdrawals at 75 percent to 90 percent of the total cash value. You’ll also have to pay an administrative fee.
You don’t have to pay back the amount you withdraw. But with a whole life policy and most cash-value policies, your withdrawal will reduce the cash value of your policy and reduce the death benefit your beneficiaries receive after you die.
One important benefit: Your withdrawals are tax-free up to the value of the total premiums you paid. The premiums you paid create your cost basis in the policy. You pay tax at ordinary income rates on the withdrawals you take that exceed your cost basis.1
For example, say you paid $100,000 in premiums for your whole life policy and the policy now has a cash value of $300,000. If you withdraw $250,000,
$100,000 is tax-free, and $150,000 is taxable.
You should receive from your insurer a Form 1099-R showing the total proceeds you received and the taxable part, if any. Report these amounts on lines 5a and 5b of Form 1040.
Surrender Your Policy
You also have the option of surrendering your permanent cash value policy to your insurer.
This means the policy is terminated, and you are paid the policy’s full cash value, less surrender fees. Unfortunately, the fees can be as high as 10 percent to 35 percent of your policy's cash value during the first several years you have your policy. The fees go down over time--usually to 1 percent (or nothing at all) after ten to fifteen years.
As with partial cash withdrawals, you will owe no tax on the portion of your surrender payout that represents a return of the premiums you paid your insurer—i.e., your cost basis in your cash value account. But you must pay tax on any amounts in excess of your cost basis at ordinary income rates.2
For example, if you paid $10,000 in premiums over the time you held the policy and you receive a $15,000 payout, the first $10,000 you receive from the surrender will be tax-free, but the remaining $5,000 will be taxed at ordinary income rates.
Take a Loan from Your Policy
When you have a permanent policy with cash value, you can also use it as collateral for a loan from your insurer. Such loans are easy to get. You don’t even need a credit check (and the loan won’t affect your credit). The loan amount is typically capped at 90 percent to 95 percent of your policy’s cash value.
This is essentially a personal loan you obtain from your life insurance company.
You must pay interest, but it can be lower than the interest charged by banks for personal loans. Moreover, unlike traditional bank loans, these loans have no repayment schedule — you decide when and how to pay the money back.
You don’t have to make any payments of principal or interest while you’re alive. The interest you owe will be added to the loan amount (negative amortization). When you die, the unpaid amount you’ve borrowed plus interest is subtracted from the death benefit before it is paid to your heirs.
If you don’t make any payments, the amount you owe could eventually exceed your policy’s cash value. If this occurs, your policy will lapse (terminate), and the insurer will use the cash value to pay off your loans. You'll also owe income tax on the amount of your cash value proceeds that exceed your total premium payments (cost basis). This is to ensure that the entire cash value is used to pay off your loan.
You can make payments while you’re alive to preserve your heirs’ death benefit and avoid having your policy lapse. Your payment options include making periodic payments of principal, with annual payments of interest; paying interest only; or deducting interest from your policy’s cash value. If you make payments from your policy’s cash value, any amounts taken from your policy's earnings are taxable income.
One unique feature of borrowing from your policy is that it does not affect your policy’s cash value. The cash value will continue to earn interest and grow tax-free. If you have a life insurance policy that pays dividends, the interest you earn on your cash value plus the dividends you receive may equal or even exceed the interest charged on your cash value loan. Like all loans, cash value policy loans are tax-free.
Some people like the idea of borrowing from their policies so much that they contribute more to their policy’s cash value so they can borrow more. This is called “overfunding.”
But beware. The IRS has established a limit on how much you can contribute. If you contribute too much, the IRS can classify your policy as a modified endowment contract (MEC).
Having your policy classified as an MEC is a tax disaster.
Withdrawals and loans from an MEC are treated as coming first from your policy’s cash value earnings and are taxable to the extent that the policy’s cash value exceeds the premiums you paid (cost basis). Also, withdrawals before age 59 1/2 incur a 10 percent penalty, subject to certain exceptions 3
Your policy will be classified as a MEC if you overfund it to the extent that it would be fully funded (requiring no further premium payments) using seven equal annual payments during the first seven years that the policy is in effect.4 This annual dollar amount is called the “MEC limit.”
Your policy’s MEC limit should be set forth in your life insurance contract. Your life insurance company should also warn you if a payment would reach the MEC limit.
Sell Your Policy to a Third Party
Finally, you may be able to sell your permanent life insurance policy to a third party for cash. This is called a “life settlement.”
The buyer—typically a bank or hedge fund—then pays the premiums and will collect the death benefit when you die. You give up both your policy’s cash value and the death benefit in return for the cash.
Your beneficiaries get nothing when you die.
The life settlement concept might seem a bit ghoulish, but you may actually receive more this way than with a policy surrender, typically, 10 percent to 25 percent of your policy’s death benefit. The shorter your probable life span, the less time the buyer of your policy will have to wait to collect, and the more it will be willing to pay you for your policy.
Specialized brokers handle these transactions—your insurance broker can find one for you. You can also deal directly with third-party purchasers and avoid broker commissions, which can be substantial. It’s a good idea to compare several quotes.
The ideal candidate for a life settlement is a person over 70 years old who is in poor health. This is not an option for policy owners younger than age 65. Also, your policy must have at least a $100,000 death benefit.
Life settlement proceeds are tax-free up to your cost basis—the total premiums you paid. Proceeds above cost basis are taxable in two tiers:5
- Proceeds over the cost basis and up to the policy's cash surrender value are taxed as ordinary income.
- Proceeds over the policy’s cash surrender value are taxed as long-term capital gains.
Example. Joseph receives a $100,000 life settlement for his cash value whole life policy with a $50,000 cash surrender value. He paid a total of $40,000 in premiums, so his taxable gain is $60,000 ($100,000 - $40,000).
- $10,000 of his gain is taxed at ordinary income rates ($60,000 gain - $50,000 surrender value = $10,000).
- His remaining $ 50,000 gain is taxed as a long-term capital gain, which is 15 percent at his income level.
Viatical Settlement
There’s a special type of life insurance settlement, called a “viatical settlement,” for policyholders who are
- Terminally ill (certified by a doctor to have less than two years left to live), or
- Chronically (disabled), with the proceeds to be used for term care not covered by insurance.
The entire proceeds from a viatical settlement are tax-free.6
Viatical settlements are typically much larger than life settlements, paying 50 percent to 85 percent of the death benefit amount, depending on the policyholder’s life expectancy. So, this is a way for a terminally ill or disabled policyholder to get a substantial sum of tax-free money.
Takeaways
Here are five takeaways from this article:
- Permanent life insurance includes a cash value account that grows over time as the policyholder makes premium payments. Policyholders can tap into their policy’s cash value while they are still alive in a variety of ways.
- Policyholders can make partial withdrawals from their cash value account. Withdrawals up to the account’s cost basis (total premiums paid) are tax-free. Withdrawals over a cost-of-living basis are taxed at ordinary income rates. Withdrawals don’t have to be repaid, but they will reduce the policy’s death benefit.
- A permanent life insurance policy can also be surrendered to the insurer, who will pay the total amount of the cash value account, less fees. The payment is taxable at ordinary income rates to the extent it exceeds the cost basis in the cash value account (total premiums paid).
- Policyholders can take out loans with their insurer using their cash value as collateral. Such loans are tax-free, but if unpaid, they will reduce the policy’s death benefit.
- Older or terminally ill policyholders have the option of selling their policy to third parties who will then make the premium payments and collect the death benefit when the seller dies. The sale proceeds are taxable to the extent they exceed the cost basis. Viatical settlements made by terminally ill or disabled policyholders are tax-free.
1 IRSPub. 525, Taxable and Nontaxable Income (2024), dated Feb. 12 12, 2025, p. 24.
2 IRCSection72(e)(5)(A).
3 IRCSection72(e)(10)(A)(i).
4 IRCSection7702A(a).
5 Rev.Rul.2009-13.
6 IRCSection101(g)(1).