When a life insurance policy is surrendered, the owner is canceling the policy for the “nonforfeiture value,” a predetermined sum of money (the surrender value). After paying out the surrender value, the insurance company that provided the coverage is no longer obligated to provide life insurance benefits to the (former) policyowner. That is, by surrendering a life insurance policy, the policyowner gives up all rights under that policy, including any death benefit payable under the policy.
Tip: Life insurance comes in two basic forms: cash value (permanent) and term. By its very nature, term insurance is temporary and generally does not build cash value. Since term life policies generally have no surrender value, they will not be discussed here. All further mention of life insurance in this article refers to cash value life insurance.
How the Surrender Is Value Determined
The surrender value is determined by adding any accumulated dividends and unearned premiums to the current cash value amount and subtracting any outstanding loans (or loan interest), and any surrender charge. To obtain the current surrender value or surrender charge, contact the insurer that issued the policy. Typically, the cash value will increase and the surrender charge will decrease as a policy ages. At some point, which can be as long as 15 to 20 years, the surrender charge will usually disappear.
Surrender Charge
There is generally a price tag attached to surrendering a life insurance policy–it’s the surrender charge. The surrender charge is the fee or penalty a policyowner agrees to pay for terminating the policy early. It is a predetermined amount typically figured as a percentage of the cash value portion of the policy. The formula for calculating the surrender charge will be found in your policy. Before surrendering a life insurance policy, discuss all options with a qualified insurance professional and/or tax professional.
Why Surrender a Life Insurance Policy?
Just as there are many reasons to purchase insurance, there are many reasons to surrender it. The reason to surrender a life insurance policy is generally straightforward–gaining access to cash. Whether the money is needed to pay health-care expenses or to build an addition on a house, surrendering a life insurance policy is one way to free up funds quickly.
Many people choose to surrender a policy when the reason they bought life insurance ceases to exist. For example, parents often purchase life insurance to ensure their children will have financial support should a parent die prematurely. However, once the children are grown and on their own, the need for the insurance no longer exists (though some parents will keep the insurance to pass along an inheritance when they die).
A policyowner may also choose to surrender a policy that no longer meets the policyowner’s needs, has become too expensive, or is not performing as well as other life insurance policies.
When replacing or exchanging one policy for another, it is possible to defer any taxable gain resulting from the surrender of the original policy.
Reasons Not to Surrender a Life Insurance Policy
In surrendering his or her life insurance policy, the policyowner is giving up all rights under the policy, including his or her right to claim the death benefit. But even if the policyowner feels there is no current need for life insurance, it is possible that a future need for life insurance will resurface. If so, the ability to purchase a new policy will depend on the individual’s circumstances at the time (e.g., the individual’s age and health).
Additionally, there are surrender charges to consider, which can be high in the early years of the policy, causing the surrender value to be reduced. Finally, there are tax consequences to consider. If the surrender value exceeds the policy’s basis (premiums paid reduced by any amount withdrawn), the difference (gain) will be subject to income tax, unless the policy is being replaced or exchanged in a qualifying transaction.
Alternatives
Policy Loan
Unless otherwise stated in the policy, a policyowner has the right to borrow against the accumulated cash value in the life insurance policy. By borrowing, the policyowner can get money from the policy without having to surrender it. The policy may even offer a better interest rate than banks are offering. This is not a typical loan, however, because it never actually has to be repaid. Any outstanding loan balance will be subtracted from the death benefit or future surrender value. Interest on life insurance policy loans is not tax deductible to individuals, though it may, in some instances, be tax deductible to businesses.
Cash Value Withdrawal
Taking a withdrawal from the cash value portion of the life insurance policy is another option. This is also known as a partial surrender. Unlike a loan, a withdrawal will permanently reduce the death benefit, but there are no interest payments as there are with policy loans. There will, however, be a tax on any withdrawals that exceed the cost basis in the policy.
Viatical Settlement
In a viatical settlement contract, a terminally or chronically ill individual agrees to sell his or her life insurance policy to a viatical settlement provider. In exchange for all of his or her rights and obligations under the life insurance policy, the individual receives a lump-sum cash payment that is a percentage of the face value of the policy (usually 40 to 85 percent). These proceeds are typically not subject to income tax. Viatical settlements apply only to terminally or chronically ill individuals, and specific qualifications must be met.
Life Settlement
Like a viatical settlement, a life settlement is the sale of a life insurance policy to a third party (e.g., life settlement company). The difference, however, is that life settlements are generally for those who are not chronically or terminally ill. The proceeds from the sale in excess of the basis (generally, premiums paid in less any withdrawals, further reduced by the amount attributable to pure insurance coverage) are taxable. Generally, gain equal to the difference between the policy’s basis and the cash surrender value is considered ordinary income for tax purposes, while the remaining proceeds from the sale in excess of the cash surrender value are taxed as long-term capital gains. However, it is important to consult a qualified tax professional for details.
Let Policy Lapse
If the policyowner ceases premium payments, the accumulated cash value in the policy will be used to pay premiums and the policy will eventually lapse (after the stated grace period expires), unless the cash value is great enough to generate dividends or interest sufficient to sustain the policy. Depending on the type of cash value policy one has, failure to pay premiums may cause the death benefit to be reduced, leaving the policyowner with a “reduced paid up” policy. Or, the life insurance company may give the policyowner an extended term policy for a designated number of years, months, and days that requires no future premium payments. Should the policy lapse, the accumulated cash value will be forfeited. However, no income tax liability will be incurred, and no surrender charges will be due.
Tax Considerations
When an individual surrenders a policy, any gain will generally be taxed as ordinary income. Gain can be calculated by subtracting the policy basis from the cash value, which includes any terminal dividends and unearned premiums. Basis represents the policy premiums that the policyowner has already paid (reduced by any amount withdrawn).
When a policy loan exists, the loan amount is subtracted from the cash value prior to calculating dividends, unearned premiums, and surrender charges, but must be added back to the cash value to calculate the total gain. The formula looks like this:
Gain = Cash value (includes terminal dividends and unearned premiums – surrender charges) + policy loan – basis
When replacing or exchanging one cash value life insurance policy for another, it is possible to defer any taxable gain resulting from the surrender of the original policy.
If you have questions, contact the Insurance Experts at Henssler Financial: experts@henssler.com or 770-429-9166.
Disclosures
The following information is reprinted with permission from Forefield, a division of Broadridge Financial Solutions, Inc. This article is meant to provide valuable background information on particular investments, NOT a recommendation to buy. The investments referenced within this article may currently be traded by Henssler Financial. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing. Henssler is not licensed to offer or sell insurance products, and this overview is not to be construed as an offer to purchase any insurance products.
