Surrendering a Life Insurance Policy: What It Really Means

What Does it Mean to Surrender a Life Insurance Policy?

Surrendering a life insurance policy means voluntarily giving up your coverage contract with the insurer to get the cash surrender value for your permanent policy. Since cash surrender value is determined based on the accumulated cash value, only permanent policy types like whole life, universal life, and variable life qualify for surrendering, and not term policies.

This option may offer temporary financial relief, but your coverage will end immediately with no payout for your family. Plus, there may be deductions in the final amount you receive, as cash surrender value is usually less than the total premium you have paid. If you receive a higher payment than the premiums you have paid, you may have a taxable event.

Why People Surrender Their Policies

There could be many reasons why people surrender their life insurance policies. Some of these are listed below:

• Higher Premiums: Premiums have become unaffordable due to job loss, decreased income, or retirement.
• Major Life Changes: Life goals have changed, and the reason the coverage was needed is fulfilled; for example, a child's education is complete, or debt is paid off.
• Immediate financial need: A sudden medical emergency or other urgent expense has occurred that requires immediate cash at hand.

Though these reasons could seem valid for surrendering your life insurance policy, it is important to weigh the pros and cons of surrendering, especially if you still have people who depend on you financially.

How is the Surrender Value of a Life Insurance Policy Calculated?

Cash surrender value is the amount you receive when you surrender your policy to the insurer. It is different from the cash value, as there are applicable deductions. Typically it is calculated as follows:

Cash Surrender Value = Cash value minus surrender charges, minus any outstanding loans and interest.

For example, if your policy has $30,000 in cash value, $5,000 in surrender fees, and $5,000 in outstanding loans including interest, your surrender value would be $20,000.

Some key points to note:

• If you previously withdrew money from your cash value, that amount will have already been deducted. 
• The surrender charges vary based on the type of life insurance policy, loans and withdrawals, and market performance. It also varies as your policy ages; the earlier you surrender, the higher the surrender fee. 
• Cash surrender charges usually decrease as your policy ages, with many insurers reducing or eliminating them after about 10 to 15 years.

When Does It Make Sense to Surrender a Life Insurance Policy?

Before surrendering a life insurance policy, you should assess your needs and calculate the benefits you might miss upon doing so. It’s good to factor in whether you still need life insurance protection and if the surrender value is worth losing the death benefit and decide accordingly.

It may make sense if:

• You no longer have dependents or debt.
• Premium becomes unaffordable.
• Surrender value can help you get out of a financial crisis.
• You are now retired and need funds to manage daily expenses.

It may not make sense if:

• Your dependents rely on your policy’s death benefit.
• You are new to the policy and have just started paying premiums.
• You haven’t considered alternatives like loans or withdrawals.

If you’re surrendering due to the financial crisis, you may explore other options to access funds, and you can see if you can pause or reduce payments instead of canceling. Avoid taking impulsive decisions to resolve short-term financial crunches.

What Do You Lose When You Surrender a Life Insurance Policy?

Surrendering a life insurance policy is generally not advisable, unless absolutely necessary. When you surrender your life insurance policy, you leave your family without financial protection. And, if you have a permanent life insurance policy you miss out on future cash accumulation potential.

Coverage Gaps and Lost Death Benefit

When you surrender a life insurance policy, your coverage ends. Thus, your family doesn’t receive a death benefit payout when you die. It’s also important to remember that obtaining coverage as you age could be expensive, as premiums rise with age due to the risk of health complications.

Missed Tax-Deferred Growth or Payouts

Your permanent life insurance policy accumulates cash value over time that grows tax-deferred. If you decide to surrender your policy and the cash surrender value is higher than the premium you have paid, you may have to pay taxes on the excess amount. You should always speak with a tax professional to see how surrendering your policy might impact you.

Tax Implications of Surrendering a Life Insurance Policy

When you surrender a life insurance policy, insurers determine the total premium you have paid over the years and the cash surrender value. Based on this:

• If the cash surrender value is less than the total premium amount you have paid, you generally will not be taxed.
• If the cash surrender value is more than the total premium amount you have paid, the excess is typically taxed as ordinary income.

The tax calculation on surrendering a life insurance policy can also be impacted by loans and withdrawals. Plus, cancelling a policy early means you no longer have the ability to grow money tax-deferred. It’s always a good idea to consult a financial advisor before surrendering a life insurance policy.

Read: Permanent Life Insurance vs Term

Alternatives to Surrendering a Life Insurance Policy

Before you decide to surrender your policy, remember that you cannot reinstate it, your beneficiaries won’t receive a payout, and most importantly, that cancellation is not the only choice you have to solve a financial crisis.

Here are some common alternatives to surrendering a life insurance policy that you should know:

• Policy Loan: You can use the accumulated cash value on your policy to borrow a loan against it as collateral or security. This keeps your policy active and helps you get a loan without a credit check. Funds are typically tax-free; taxes apply only when your policy lapses with an outstanding loan.
• Cash Value Withdrawal: If not a loan, you can also withdraw a portion of your policy’s cash value. This option can help you fund moderate cash needs. Though loans and withdrawals may reduce the death benefit for the beneficiaries, they still keep your coverage active in comparison to when you surrender a policy. Taxes apply only when the withdrawal amount is greater than the premiums you’ve paid.
• Reduced Paid-Up Option: If you own a whole life policy and you’re cancelling as you’re not able to manage premiums, you can consider this option. You can request your insurer to convert your coverage to a reduced paid-up policy that doesn’t need further premium payments. This ensures your policy continues, but with lower benefits than the original amount.
• Extended Term Insurance: This is another option for those who are surrendering because of unaffordable premiums. Some insurers may also allow you to use your accumulated cash value for the purchase of a term insurance with an equivalent death benefit. Coverage lasts for a set number of years with no additional premiums, offering a temporary relief.

Surrendering vs. Selling Your Life Insurance Policy

Surrendering a life insurance policy does not mean you are selling it. Surrendering means terminating the policy for its surrender value, whereas selling the policy is termed as life settlement, where you sell your policy to a third party. In both cases, your coverage ends. Here is a comparison between the two:

Surrendering or selling your policy can have different outcomes, based on the policy type, premiums paid, and other factors. It is always a good idea to consult a financial advisor before making the final decision.

Read: Affordable Life Insurance For Seniors Over 60

How to Surrender a Life Insurance Policy (Step-by-Step)

If, after calculating all pros and cons, you have decided to surrender your policy, here are some steps to follow:

1. Read the Fine Print: Thoroughly review the policy documents and understand the surrender clause, fees, and your current cash value.
2. Request for a Surrender: To begin the process, contact your insurer, and request a policy surrender form along with a written request of the payout.
3. Gather the Details: The insurer might need information like your policy number, ID, and other details. Keep important documents handy.
4. Wait for the Response: Insurance companies usually process the surrender requests within 2 to 4 weeks.

After the confirmation, companies make the payout via a check or a direct deposit after making the required deductions as outlined in the policy.