Can You Cash Out Life Insurance While You’re Alive?

You can cash out life insurance while you’re alive, but only if you own a permanent policy with built-up cash value, and the method you choose determines how much you keep, how much the IRS takes, and what your beneficiaries lose. The five routes are a partial withdrawal, a policy loan, a full surrender, an accelerated death benefit, or a sale on the secondary market. Each one has its own tax rules and its own trade-offs.

Term life insurance is the boundary case worth naming up front: it builds no cash value, so there is nothing to cash out while you’re alive. When a term policy expires, you get nothing back. The rest of this article assumes you hold a permanent policy — whole life, universal life, variable life, or indexed universal life — where part of each premium funds a cash value account that grows over time.¹

Partial Withdrawals

A partial withdrawal pulls a specific dollar amount out of your cash value and leaves the policy in force. Your remaining cash value drops, and your death benefit typically shrinks by at least the amount you took.

The tax treatment is the main attraction. On a standard (non-MEC) policy, withdrawals come out of your cost basis first — the total premiums you’ve paid in. As long as you withdraw less than that basis amount, you owe no income tax.² Only the excess above your basis is taxed as ordinary income.³

Most insurers also require a minimum balance to stay in the policy after a withdrawal. Pull too much and the insurer may reduce your death benefit disproportionately or force the policy to lapse. Check the withdrawal provisions in your contract before you request funds.

Policy Loans

Borrowing against your cash value is not a withdrawal. The insurer lends you money from its own reserves and holds your cash value as collateral. The full cash value stays in place and keeps earning interest or dividends while the loan is outstanding.

Interest rates on policy loans typically run between 5% and 8% per year. There’s no application, no credit check, and no required repayment schedule. You can pay it back on your own terms or never. If you die with a balance outstanding, the insurer subtracts the loan plus accrued interest from the death benefit before paying your beneficiaries.

The trap is compounding. If you ignore the loan and the interest keeps piling up, the total owed can eventually exceed your cash value and the policy lapses. When it does, the IRS treats the entire gain — your cash value above your cost basis — as taxable income, even though no check ever reached you. Owing tax on money you never pocketed is one of the harshest surprises in life insurance planning, and it tends to hit people who treated policy loans as free money for years without watching the balance.

Full Surrender

Surrendering the policy cancels it. You get the cash value minus any outstanding loan balance, accrued loan interest, and surrender charges.

Surrender charges hit hardest in the early years. Most permanent policies impose them for roughly the first 10 to 15 years, often starting around 7% or higher and declining each year until they reach zero. The exact schedule is in your contract.

Tax-wise, anything you receive above your cost basis is ordinary income.² If your policy holds $80,000 in cash value and you paid $50,000 in premiums over the years, the $30,000 gain is taxable. A big surrender can push you into a higher bracket for that year, so the timing of the surrender matters as much as the decision to do it.

Accelerated Death Benefits

Many permanent policies include a rider that lets you collect part of the death benefit early if you’re diagnosed with a terminal or chronic illness. Some policies bundle this rider in automatically; others charge a small extra premium.

For terminal illness, most policies require a physician’s certification that your life expectancy is 24 months or less.⁴ Chronic illness triggers generally require certification that you can’t perform at least two activities of daily living without substantial help, or that you need supervision due to severe cognitive impairment. The amount available typically ranges from 25% to 100% of the face value, and whatever you take is subtracted from what your beneficiaries eventually receive.⁵

The tax treatment is the most favorable of any living-benefit option. Accelerated death benefits paid to a terminally ill individual are completely excluded from gross income — the IRS treats them as if they were a regular death benefit.⁴ For chronically ill individuals, the exclusion applies to payments used for qualified long-term care services, subject to annual limits.

Selling the Policy

Instead of surrendering it back to the insurer, you can sell your policy to a third-party buyer. The buyer takes over the premiums and eventually collects the death benefit. You get a lump sum that is usually more than the surrender value but less than the face amount. Two versions of this transaction exist, and the tax treatment is very different.

Viatical Settlements

A viatical settlement is for people who are terminally or chronically ill. You sell the policy to a licensed viatical settlement provider, and the proceeds are entirely tax-free under federal law — the IRS treats the payment as a death benefit paid by reason of death.⁴ The provider must be licensed in your state or meet standards set by the National Association of Insurance Commissioners, and the physician certification requirements mirror those for accelerated death benefits: life expectancy of 24 months or less for terminal illness, or inability to perform at least two daily living activities for chronic illness.⁶

Life Settlements

A life settlement is the same kind of sale for people who aren’t terminally or chronically ill — typically seniors over 65 who no longer need the coverage or can’t afford the premiums. Life settlements don’t qualify for the tax-free treatment. The proceeds are taxed in three layers:

The portion up to your cost basis is tax-free.
The portion between your cost basis and the policy’s cash surrender value is taxed as ordinary income.
Anything above the cash surrender value is taxed at capital gains rates.

Life settlement brokers charge a commission, and the buyer will do medical underwriting to estimate your life expectancy. Most states regulate these transactions and require the broker or provider to be licensed. Offers can vary a lot, so get quotes from multiple providers before accepting one.

The Modified Endowment Contract Trap

If you overfund a life insurance policy — paying in more than the IRS allows during the first seven years — the policy is reclassified as a modified endowment contract, or MEC. The reclassification is permanent and irreversible, and it undoes most of the tax advantages that make cashing out attractive in the first place.

The test: cumulative premium payments during the first seven contract years cannot exceed what it would cost to fully pay up the policy with seven level annual premiums.⁷ Your insurer calculates this 7-pay limit at issue. Exceeding it in any year inside the window makes the policy a MEC from that point forward. Material changes, such as increasing the death benefit, can restart the seven-year testing period.

Once a policy is a MEC, two rules change the math on every living benefit:

Gains come out first. Every withdrawal or loan is treated as taxable income until all the gains have been distributed. Even policy loans count as taxable distributions.³
A 10% early distribution penalty applies to any taxable distribution taken before age 59½, on top of ordinary income tax. The penalty doesn’t apply if you’re disabled or receiving substantially equal periodic payments.⁸

The death benefit still pays out tax-free to beneficiaries, so a MEC isn’t useless. But it loses most of the living-benefit flexibility. If you expect to tap cash value during your lifetime, keep premium payments under the 7-pay limit.

1035 Exchanges

If you want out of a policy but don’t want the tax bill from a surrender, a 1035 exchange lets you move the cash value directly into a new life insurance policy, an endowment contract, an annuity, or a qualified long-term care policy with no gain or loss recognized.⁹ Your cost basis carries over.

The transfer must go directly between insurance companies; you can’t take the money and reinvest it yourself. It also has to run in a permitted direction. Life insurance can move into another life policy, an annuity, or long-term care coverage, but an annuity can’t move into a life insurance contract. For a policy with significant gains and a high surrender charge, this is often the cleanest way to switch into coverage that fits your current needs.

What to Expect When You File

Whichever method you use, you’ll submit paperwork to your insurer. Have your policy number and a government-issued ID ready. Surrenders use a surrender request form, partial withdrawals use a withdrawal application, and accelerated death benefit claims require a physician’s certification along with the insurer’s claim form. Most forms are available on the insurer’s website or by calling customer service.

For a 1035 exchange, the receiving insurance company usually initiates the paperwork. State the exact dollar amount or percentage you’re moving and confirm whether the disbursement will come as an electronic transfer or a check, with the correct account or mailing details.

Processing typically takes one to three weeks while the insurer verifies the policy is active, confirms no liens or court orders restrict the payout, and authenticates your identity. Accelerated death benefit claims can run longer if the insurer wants more medical documentation. Any outstanding loan balance is subtracted before funds are released. Keep copies of every form and every piece of correspondence; disputes are far easier to resolve when you can point to exactly what you submitted and when.

1
Office of the Law Revision Counsel. 26 USC 7702 – Life Insurance Contract Defined
2
Internal Revenue Service. Are the Life Insurance Proceeds I Received Taxable?
3
Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
4
Office of the Law Revision Counsel. 26 USC 101 – Certain Death Benefits
5
Insurance Compact. Additional Standards for Accelerated Death Benefits for Individual Life Insurance Policies
6
Internal Revenue Service. Instructions for Form 1099-LTC
7
Office of the Law Revision Counsel. 26 USC 7702A – Modified Endowment Contract Defined
8
Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts – Section 72(v)
9
Office of the Law Revision Counsel. 26 USC 1035 – Certain Exchanges of Insurance Policies