What to consider before cashing out insurance

If you need access to cash, you may be tempted to cash out your permanent life insurance policy.

And while it won’t affect future insurability, there’s a tax hit if you surrender your policy prior to death. That’s because permanent insurance policies (Universal Life or Whole Life) have an investment component that’s tax-sheltered. Pulling out cash early means you’ll have to pay tax on that income.

Elli Schochet, an associate at Al G. Brown & Associates in Toronto, says the amount of tax you have to pay depends on the ACB of the policy. The ACB is determined through a complex CRA calculation, but in short, it’s made of the premiums put into the policy, less the net cost of pure insurance.

If the ACB is $20,000, and there’s $100,000 built up in a policy, the client would pay tax on the remaining $80,000.

And how long you’ve had the policy makes a difference. “The best time to cancel and have the lowest tax impact is probably within the first few years,” says Schochet. “The longer the policy has been in place, the higher the percentage of the cash value that’s taxable.”

While the tax impact may be lower early on, Ashley Rodrigues, director, Insurance Solutions at BMO Insurance in Toronto, says it usually isn’t appropriate to cash out over the short term.

“The primary purpose of life insurance [is] committing to a long-term plan,” he says. “If [you’re] going to access all the funds over the first few years after that policy goes in place, life insurance is probably not the best vehicle to do that.”

Cindy David, senior estate planning advisor at Raymond James Financial Planning Ltd. in Vancouver, agrees there are better options than a full surrender. “I often tell clients the last buckets they should spend from are their TFSAs, and any cash-value life insurance policies” because those buckets are growing tax-free and also tax-free in the estate.

Here are a few alternatives if you’re cash strapped and have a permanent life policy.

1. Opt for a partial surrender

Perhaps you can make do with some cash in the policy. If that’s the case, you can do a partial surrender, which allow you to retain the insurance.

Let’s use the same example from above. You have $100,000 built up in your policy and need access to $30,000. The ACB is $6,000, so you’d be taxed on $24,000. Even though the amount that’s taxed is less, the percentage taxable is still the same at 80%.

Also, Schochet notes it’s easier to partially surrender a UL policy than a WL.

“In certain types of whole life policies, one of the dividend options uses the dividends to purchase paid-up additions of insurance,” he explains. “When you take a partial surrender by way of surrendering dividends, you’re also reducing the paid-up additions of insurance that were bought by those dividends.

“Over time, paid-up additions of insurance are added to the base coverage that was bought, which equals the total amount of coverage. When you surrender the cash value it reduces the paid-up additions. So both the cash value and overall death benefit are affected.”

But say you have $100,000 of cash value in a face-plus-fund UL policy (i.e., the cash value is paid out together with the death benefit on a tax-free basis), and the face amount of the insurance is $500,000. If you die, your estate would get a $600,000 death benefit , says Schochet. “If [you] take out $50,000 in cash, [your] estate will still get a $550,000 death benefit.”

2. Take out a policy loan

Both UL and WL allow you to take out loans from the insurer, using the policy as collateral. The option lets you access cash without surrendering your policy.

“You’re essentially borrowing from the cash value that you’ve built up in the policy with the objective of paying it back at some future point,” says Rodrigues. “This would allow the policy to continue to grow without disrupting any of the growth in the cash value that they’re borrowing against.”

But you’ll be on the hook for interest payments. And there’s still a tax consideration, because the loan is considered an advance payment of a policyholder’s entitlement for tax purposes.

Policy loans are first drawn against the tax-free ACB of the policy (it’s a withdrawal of the policyholder’s original capital, so the funds come out without tax consequence). Any amount withdrawn beyond the ACB is taxed as regular income.

Using the same example where you have a cash value of $100,000, let’s say you take out a $30,000 policy loan.

“We said the adjusted cost base before the loan was $20,000,” says Rodrigues. “So the $30,000, less the $20,000, equals $10,000 that would be taxable income.” (If the loan was $15,000 instead, and the ACB was $20,000, there wouldn’t be any taxable income to report.)

“And if the loan is repaid, a tax deduction is available to the policy owner for the amount repaid, up to the taxable income declared when the original loan was taken (e.g., $10,000 in former example),” says Rodrigues.

“The portion of the loan repayment in excess of the deductible amount claimed would be added back to the ACB of the policy. If the tax deduction is not claimed, the full amount of the repayment would be added back to the ACB.”

To be able to write off interest costs, you’d have to be investing the loan proceeds.

3. Use the policy as collateral with a third-party lender

Another way you can get cash is to approach a bank or credit union. Like before, the life insurance policy is assigned as collateral to secure a line of credit or loan — but the lender is external.

While there is no taxable income, you still have to pay interest, which can be higher than typical bank loans — the rate depends on the lender. And clients must get approved, so lenders will assess creditworthiness, as well as the collateral. Schochet adds with WL, the bank loan generally cannot exceed 90% of the cash value; 75% with UL if it’s in guaranteed investments like GICs (50% if in equities) .

Loan payment

When it comes to payment, it depends on if the loan is from the insurance company or bank.

“The insurance company will normally require they pay interest on the loan during their lifetime, and the loan is paid off at death [with the death benefit proceeds],” says Schochet. “Banks have different arrangements and may allow the interest to be capitalized. So you don’t pay the interest during the period you’re alive — it’s just accumulated until death.” For instance, if the policy has a $250,000 death benefit and the loan is $100,000 after interest, the estate would get $150,000.

David adds age plays a factor when borrowing. “If you’re in your 50s, [it may be cheaper to] just withdraw because you don’t want to be paying interest for 40 years. But if you’re in your late 60s, early 70s, I’d talk about borrowing.”