Your life insurance policy could help you through financial hardship.

The economy has been hit hard by the COVID-19 pandemic.

Many people have lost their jobs or had their hours reduced.

Perhaps you or your spouse are among them.

You anxiously review your bank account and your bills.

You wonder how you will make ends meet.

According to a recent Investopedia article titled “Cashing in Your Life Insurance Policy,” one option may be to cash in your life insurance policy.

Cashing in your life insurance policy may trigger unintended consequences for your estate plan.

This method is not ideal because it could compromise future goals for yourself or your family.

In some instances, your life insurance may be your best source for the current income you need.

A "cash-value" life insurance policy is usually best for these needs.

What is cash-value life insurance policy?

Unlike "term" insurance, cash-value insurance (universal or whole life insurance) builds tax-advantaged cash reserves.

It builds these reserves through its excess premiums plus earnings.

Your premiums are held within the policy in a cash-accumulated account.

You can access these cash savings through policy loans, withdrawals, or a full or partial surrender of the policy.

You also could sell your policy for cash.

Selling your policy is referred to as a life settlement.

Although withdrawals can be helpful, they can have negative consequences as well.

How so?

Making withdrawals may reduce your death benefit.

This would limit the money available for your family for the very purposes for which you acquired the policy in the first place, whether for wealth preservation, business continuation, or income replacement.

Taking a withdrawal from your policy may also trigger penalties.

Taking withdrawals within the first 15 years of the policy can cause the policy death benefit to be reduced and all (or some) of these cash withdrawals could be subject to taxes.

If your withdrawal reduces the cash surrender value of your policy, you could see a rise in your premiums to maintain the same death benefit.

If not, your life insurance policy could lapse.

With a cash value policy, your withdrawals will generally not be taxable up to your policy basis if your policy is not a modified endowment contact.

What is a modified endowment contract?

These life insurance polices have funding in excess of the federal tax law limits.

The withdrawals are subject to applicable annuity rules.

What does this mean?

Withdrawals are considered to be made from interest (not from principal) first.

This means they will be subject to income taxation and potentially trigger a 10 percent penalty for early withdrawal if you are younger than age 59½.

How much money can you borrow from the issuer of the life insurance policy if you use your cash-accumulation account as collateral?

This depends on the terms of your contract and the value of your cash-accumulation account.

When you borrow from a non-modified endowment contract policy, you will not be taxed on the loan.

You also will not be required to make payments on the loan, but your loan balance may be accruing interest.

Your loan will likely decrease your death benefit.

This means your beneficiaries will receive less financial support and protection from your account if you die.

An unpaid loan will reduce your cash value when it accrues interest.

This means your life insurance policy may lapse if you do not make sufficient premium payments to maintain the death benefit.

What happens if your loan is outstanding when you surrender the insurance or your policy lapses?

Taxes, and potentially heavy taxes at that.

Loans from a modified endowment contract policy are treated as distributions.

This means the same rules and penalties apply as if you were making an withdrawal.

If you choose to cancel or surrender your policy, you will receive the cash according to your preference.

Surrendering your life insurance policy means you are giving up your death benefit completely.

If you surrender the policy in the early years of taking ownership, you will probably be subject to surrender fees.

These fees may drop the cash value.

If there was a gain on the surrendered policy or an outstanding loan on the policy, these could be taxed.

Another option you may have is to sell your policy to a life settlement company or an individual.

The new owner will pay the premiums.

What should you know about life settlements?

The individual or company has control of your death benefits.

They may have access to your past and future medical records.

It may be hard to know if you are getting a fair price for your policy.

Commissions fees may also reduce the net amount you receive.

Although cashing in your life insurance policy can help you in a time of financial need, it is likely best to explore other options first.

Reference: Investopedia (Aug. 11, 2019) “Cashing in Your Life Insurance Policy”