Withdrawing cash value from a life insurance policy

A partial withdrawal takes money out of a permanent policy's cash value permanently, with no loan and nothing to repay. Withdrawals up to your cost basis (generally the premiums you have paid) are usually tax-free on a policy that is not a modified endowment contract, but they typically reduce the death benefit, may carry fees or surrender charges, and are not always available at all.

Which policies allow withdrawals

Rules differ by product:

• Universal life, indexed universal life and variable universal life. Withdrawals are usually allowed, subject to a minimum amount, a per-withdrawal fee, and a requirement that enough cash value remain to keep the policy in force. These are the policies where "withdrawal" is a routine feature.
• Participating whole life. Most contracts do not offer a free-form withdrawal of base cash value. You can usually take dividends in cash, or surrender paid-up additions riders explained in part. Borrowing against the policy is the more common route (see life insurance policy loans: how they work and what they risk).
• Term life. No cash value, so nothing to withdraw.

Your contract's "partial surrender" or "withdrawal" provision spells out what applies. Read it before counting on the money.

Withdrawal, loan or surrender: how they differ

See surrendering a life insurance policy: what you get and what it costs for the full-surrender route.

What a withdrawal does to the death benefit

It depends on the policy design.

• In a universal life policy with a level death benefit (often called Option A or Option 1), a withdrawal usually reduces the face amount, commonly dollar for dollar, because the death benefit is tied to the cash value under the section 7702 tests. See Universal life death benefit options A and B.
• With an increasing death benefit option, the cash value is added on top of the face amount, so a withdrawal reduces the death benefit by the amount withdrawn.
• A reduction in face amount can trigger a surrender charge on the portion removed in some contracts.
• In whole life, surrendering paid-up additions reduces the paid-up coverage they purchased.

Ask the insurer for a written illustration of the policy after the withdrawal, not just the current numbers.

How withdrawals are taxed

Tax rules for withdrawals come from Internal Revenue Code section 72(e) and section 7702. The full treatment is in how cash value is taxed: withdrawals, loans and surrenders; the essentials:

1. Non-MEC policy: basis first. Withdrawals are generally treated as a return of your basis first, so they are tax-free until total withdrawals exceed it. Amounts above basis are ordinary income.
2. Exception for early benefit reductions. If a withdrawal comes with a reduction in benefits during the first 15 years, Section 7702(f)(7) can require part of it to be taxed as gain first. This catches people who reduce coverage soon after buying.
3. Modified endowment contract: gain first. If the policy is a modified endowment contracts and the 7-pay test, withdrawals come out gain first and are taxed as income, and a 10% additional tax generally applies to the taxable amount before age 59½.
4. Dividends taken in cash. The IRS (Publication 550) treats policy dividends as a return of premium, not taxable until they exceed the net premiums paid. That also lowers your basis.

Basis is the premiums you paid, reduced by dividends received in cash and by tax-free withdrawals. Keep your premium records; some insurers report cost basis on request.

Hypothetical example

Say a 50-year-old owns a universal life policy with a $300,000 level death benefit, $70,000 in cash value, and $55,000 of total premiums paid (basis). The policy is not a MEC and is past year 15. These numbers are invented for illustration.

• The owner withdraws $20,000. That is under the $55,000 basis, so it is generally tax-free, and the basis falls to $35,000.
• The face amount may fall by about $20,000 to $280,000, depending on the contract.
• Cash value drops to $50,000, and monthly cost-of-insurance charges keep drawing on it. If the policy is underfunded, a lower cash value means a shorter runway before it lapses.
• A later $40,000 withdrawal would exceed the remaining $35,000 of basis by $5,000, and that $5,000 would be taxable. Taking out that much would leave only about $10,000 of cash value, so the policy could be at risk of lapsing.

Before you withdraw

1. Check if you are within the surrender period. Withdrawals beyond a free withdrawal provision may incur charges. See life insurance surrender charges explained.
2. Request a post-withdrawal illustration that projects the policy to a very old age on current and guaranteed assumptions.
3. Compare with a loan. If you can repay, a loan may preserve the death benefit better; if you will not repay, a withdrawal avoids compounding interest. Test the numbers in the policy loan calculator.
4. Ask whether the policy is near its MEC limit or has had a recent reduction in benefits.
5. Consider the larger decision. If you no longer want the coverage, compare keeping, surrendering and selling with the keep, surrender or sell your policy?; a 1035 exchanges: swapping policies without tax may also be an option.

Key takeaways

• A withdrawal permanently removes cash value; it is not a loan and does not accrue interest.
• Many permanent policies, especially universal life, allow it; most whole life policies limit it to dividends or paid-up additions.
• On a non-MEC policy, withdrawals are generally tax-free up to basis; on a MEC they are taxed gain first, with a possible 10% additional tax before 59½.
• Withdrawals often reduce the death benefit and can raise lapse risk in underfunded policies.
• Get a written post-withdrawal illustration before you act.