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What Is Cash Surrender Value of Life Insurance?

The cash surrender value is the money a person receives from their insurer upon canceling their life insurance policy before the policy’s maturity or the person’s death. It comes from the savings portion of whole life, universal life, and other permanent life insurance policies. The cash value is also called the policyholder’s equity. It takes time for a policy to build cash value.

Key takeaways:

Eventually, the cash surrender value may prove helpful for paying premiums, taking a policy loan, or withdrawing entirely for access to your funds. However, cashing in isn’t always the best financial decision, so proceed with professional advice.

What is the cash surrender value of life insurance?

Certain types of life insurance have a cash savings component, which policyholders can access in part or whole while living. The insurer disburses the death benefit but keeps this cash savings when the policyholder dies.

The cash surrender value is what a policyholder gets if they withdraw all the cash savings from the policy before the policy matures. This is when the policyholder reaches a certain age, usually between 100 and 121 years old, as spelled out in the policy.

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How does cash value grow?

As a policyholder makes premium payments on their policy, the cash value builds over time. Certain policies, known as participating policies, also issue dividends to their policyholders. The dividends accumulate without tax liability.

The cash value earnings in life insurance grow tax-deferred until:

  • You cash in (surrender) the policy
  • You sell or assign the policy
  • The policy no longer meets the IRS criteria for a life insurance contract

If you cancel your policy, you’ll get back what you paid in premiums tax-free. However, if you receive more than what you paid in premiums, the excess will be taxable income. If you leave your dividends in the policy, any interest earned will also be considered taxable.

Is the cash surrender value taxable with the IRS?

The cash surrender value of a policy is not taxable unless it does not meet the IRS Tax Code 7702 criteria. This code defines the tax status of permanent life insurance contracts. It also ensures that a life insurance policy is set up for a death benefit payout instead of as an investment vehicle.

Tax Code 7702 also restricts how much you can pay in premiums before the IRS considers your policy a taxable investment. Beyond that threshold, any loans or withdrawals taken from the cash value could be taxable.

Qualifying for Section 7702 tax benefits

To qualify for tax advantages, your policy must be a “life insurance contract,” as the IRS defines it. It must also pass either the Cash Value Accumulation Test (CVAT) or the Guideline Premium and Corridor Test (GPT). A policyholder selects which test they want to use when completing their application.

Cash Value Accumulation Test (CVAT)

The CVAT determines whether the policy is set up as a tax shelter or investment tool. If your policy accumulates cash value too quickly, it will be considered an investment and fail the test. Consequently, it will forfeit its tax advantages under Section 7702.

Guideline Premium and Corridor Test (GPT)

The two-part GPT is used to attest that the policy’s premiums and death benefit remain within certain limits. It entails the Guideline Premium Test and the Corridor Test.

  • Guideline Premium. The maximum amount of premiums that can go into a policy without making it a Modified Endowment Contract (MEC). An MEC is an overfunded life insurance policy that no longer meets the IRS 7702 requirements.
  • Corridor. The difference between a policy’s cash value and the death benefit. If the cash value goes above the Corridor, the policy is overfunded and will be considered an MEC.

Your life insurance agent can verify your policy’s tax status. Moreover, the company should perform routine checks for compliance with Code 7702. They should also help you understand if increasing premium payments would affect your policy’s compliance as well.

What happens when you sell your policy

If an individual no longer needs, wants, or can afford their whole life insurance, they can sell the policy as a life or senior settlement. This may work if you find cheaper insurance or need immediate access to a large amount of cash.

In exchange for a cash lump sum payment, the buyer would assume responsibility for any additional premiums due while you live. The insurance company will pay the death benefit to the buyer when you die.

The lump sum payment amount will depend on factors including age, health status, and policy terms. These disbursements are typically higher than the policy’s cash surrender value but lower than the net death benefit.

Questions to ask your policy buyer

The National Association of Insurance Commissioners recommends learning about all viable options before deciding on a life settlement. You can ask the life settlement professional:

  • Are they licensed in your state?
  • What fees do they charge?
  • Will a large, small, or individual investor buy the policy?
  • How will they protect your privacy?

Risks of selling your policy

Surrendering and selling your life insurance policy may save you more money, but it could cost you and your survivors in other ways. For instance, you may face these inconveniences:

  • Loss of death benefit. Once you surrender the policy, your survivors would no longer be entitled to a payout upon your demise. You would have to qualify for a new policy, which may cost more or be impossible due to aging or illness.
  • Impact on taxes and assistance. Your lump sum payment might be taxable. It could also affect your eligibility for public assistance benefits such as Medicaid or food stamps.
  • Finding a fair price. It can be time-consuming and difficult to shop around for a reasonable estimate of your policy. You may need to contact multiple life settlement companies or subject yourself to sales calls.
  • Less than full value. A settlement company or broker will charge a fee for connecting you with an interested buyer. This will reduce your total payout.

How to calculate the cash surrender value of life insurance

The cash surrender value of a whole life policy is the policy’s guaranteed cash value plus the value of dividends accrued in the policy. The universal life cash surrender value is the policy’s current cash value.

Surrender fees decrease over the term of the policy. Also, outstanding loans decrease the cash surrender value and death benefit. You can obtain the exact cash surrender value of your life insurance from your agent or financial adviser.

Surrendering your life insurance policy may help you with immediate financial needs but involves various risks. Discuss options with your insurer, financial professional, or tax advisor to determine if this suits your situation.

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