You may receive a portion of the cash value when you terminate a whole life insurance policy
Depending on the specific details of your whole life contract and how long the policy has been in force, you may also receive some of the cash value if you terminate the plan.
Term vs. Permanent Life Insurance
Life insurance policies are divided into two basic categories: term and permanent. Term insurance provides coverage for a specified duration, at the end of which, coverage ceases unless significantly higher premiums are paid. Permanent insurance provides coverage for your entire life, and premiums for these policies are designed to remain level. Whole life is the oldest form of permanent life insurance.
Cash Value Accumulation
Permanent life insurance policies accumulate equity over time. For at least the first several years after coverage begins, a portion of each premium payment is set aside into a separate account within the policy, called cash value.
This account may increase in value depending on the type of permanent policy you own and the performance of the investments used to generate the interest. Whole life policies often credit the cash value account in the form of dividends, which are typically considered a return of premiums paid if the insurance company's investments perform well.
Surrendering Your Policy
Most whole life insurance policies contain provisions allowing the insurance company to keep a portion of your cash value if you cancel your policy. The amount kept by the company when you terminate coverage is called the surrender charge, and these amounts differ between policies and insurers.
Whole life insurance contracts usually limit the length of time during which the company can penalize you for dropping the coverage, but times vary and are often in excess of 10 years. The amount of money you would receive upon terminating coverage depends on how long you've owned the policy, the surrender charges and the cash value. After the company subtracts their penalty fees, if any, from your cash value, any remaining money is yours.
Income Tax Liability
When you cash out a whole life insurance policy, you might have to pay income taxes on a portion of the money you receive. If the amount returned to you by the insurance company is greater than the total you paid in premiums, the excess is considered income and must be included in your taxable earnings for the year.
It is your responsibility to demonstrate to the IRS how much of the money received is a return of premium versus excess earnings.
Article originally published on The Nest (10/18/2012)
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