Cash Value: Withdraw or Take a Loan?

One of the greatest advantages of permanent life insurance is the ability to access the policy’s cash value. This financial feature provides flexibility during your lifetime, but it’s important to understand your options and how they may affect your policy’s long-term value. Two common ways to tap into the cash value are withdrawing money directly or taking a policy loan. Each method has its benefits and drawbacks, and knowing the differences can help you make a more informed decision.

Withdrawing Cash Value

How It Works

When you withdraw money from your life insurance policy, you are taking a portion of the cash value that has accumulated. This is similar to withdrawing funds from a savings account—once it’s gone, it’s no longer part of your policy meaning, whatever your total cash value available is, that number is subtracted by the amount withdrawn.

Benefits of Withdrawing

• Immediate Access to Funds: Withdrawals provide quick access to cash with no repayment requirement.

  
  

• Tax Advantages (in some cases): Withdrawals are generally tax-free up to the amount of premiums you’ve paid into the policy (your cost basis). The cost-basis is the amount total premiums paid on a policy minus the total dividends received, if applicable.

  • Important Note* Not all permanent policies offer dividends; only participating, mutual companies offer dividends.

    
    

• No Interest Payments: Unlike loans, you don’t pay interest on the money you withdraw.

Benefits Example: Paying for College

Imagine a parent whose only child is entering community college. They decide to withdraw $25,000 out of the $40,000 available through cash value from their life insurance to cover the cost of tuition all four years. This provides quick funds with no loan repayment, but it permanently reduces the policy’s cash value to $15,000. This means that each year, growth is now accumulating from $15,000 instead of $40,000, thus, disrupting the compound growth potential.

If they had taken a policy loan instead, growth would continue to accumulate from $40,000 but they would have to pay the money back at a low interest rate. They decided to eliminate the debt potential and worry of repayment by withdrawing the funds instead knowing that their child would still get paid a lump sum, tax-free death benefit upon their passing.

Drawbacks of Withdrawing

• Reduced Death Benefit: Withdrawing may decrease your policy’s death benefit, depending on how much is withdrawn. This means your beneficiaries will receive less. Ask your agent how this works and how to avoid reducing the death benefit when withdrawing funds.

  
  

• Potential Tax Liability: If you withdraw more than your cost basis, the excess is considered taxable income.

  • See above for a definition of 'cost basis.'

    
    

• Irreversible Action: Once withdrawn, those funds are permanently removed from the policy and will not grow back.

Drawbacks Example: Paying for College

Imagine a parent whose first child is entering community college. They have two more children they hope to put through college as well. They decide to withdraw $25,000 out of the $40,000 available through cash value from their life insurance to cover the cost of tuition all four years. This provides quick funds with no loan repayment, but it permanently reduces the policy’s cash value to $15,000.

Now, three years later, the parent is looking to withdraw more cash value to cover the cost of tuition for the second child entering into community college. However, since the cash value was reduced to $15,000, it has only accumulated to $17,700 by the end of year three (based on a 6% rate of return). This is not enough to cover the cost of tuition so the parent withdraws more than $17,700.

Now, there is no available funds in the cash value, the death benefit has reduced, and the parent is facing tax implications for withdrawing more than the premiums paid. Not only that, but depending on how much was withdrawn, the parent may lose the policy altogether. This means that there will be no death benefit for any of the children upon the parent's passing.

Policy Loans Against Cash Value

How It Works

A policy loan allows you to borrow against your cash value without actually removing it. The insurance company lends you money, using your policy’s cash value as collateral.

Benefits of Policy Loans

• Cash Value Continues to Grow: Because the cash value itself remains in the policy, it can continue earning interest or dividends.

  
  

• No Credit Check Required: Your policy guarantees the loan, so approval is automatic. This is huge for individuals with poor credit.

  
  

• Flexible Repayment Options: You can repay on your own schedule, and some clients choose to let the loan balance be deducted from the death benefit.

  
  

• Generally Tax-Free: As long as the policy remains in force, policy loans are not taxable.

Benefits Example: Starting a Business

Someone borrows $50,000 against their life insurance cash value instead of applying for a bank loan to purchase a local laundromat. The amount borrowed is 70% of the cash value in the policy (total cash value is $71, 428). The business takes about 3 months to set up before they start seeing a profit, so it's not until then that they start paying back the loan on the policy.

There were no additional fees to pay the money back three months later, and because they didn't take the full 100% cash value, their policy didn't lapse. After 3 months, the business owner starts making monthly payments and in 2 years, the loan is completely paid back. Their cash value has continued to compound from the $71,428 cash value in the account 2 years prior and the business owner can take another loan or they can allow the cash value to keep compounding which they use to cover their retirement down the road.

Drawbacks of Policy Loans

• Accruing Interest: Policy loans charge interest, and unpaid interest compounds over time.

• Reduced Death Benefit if Unpaid: Any outstanding loan balance (including interest) reduces the payout to beneficiaries.

• Risk of Policy Lapse: If the loan grows too large relative to the cash value, the policy could lapse—triggering taxes and ending coverage.

Drawbacks Example: Starting a Business

Someone borrows $50,000 against their life insurance cash value instead of applying for a bank loan to purchase a local laundromat. They borrowed 100% of the cash value in the policy and receive a letter in the mail they will need to start making payments of X amount in order to keep the policy active. The business owner is still in month 1 of running the laundromat and it is not yet profitable. They don't have a way to pay back the loan and the policy lapses and they lose their coverage. Also there may be some tax implications as well.

Important: Borrow Responsibly!

Financial professionals generally advise borrowing no more than 80% of your available cash value. This guideline provides a buffer to prevent the loan from overwhelming the policy. If too much is borrowed and interest accrues faster than growth, the policy may collapse, leaving you without coverage and possibly facing a large tax bill.

Which Option Is Right for You?

• Withdrawals may be better if you need a smaller, one-time amount and don’t want to deal with repayment. If using for college education, emergency funds or other debt elimination and debt consolidation strategies, then withdrawing money may be better option.

  
  

• Policy loans may be more appropriate if you want to preserve your cash value’s long-term growth while still accessing funds, as long as you’re disciplined about repayment. Keep in mind that the interest paid on their loans are typically lower than interest rates offered from conventional banks through business or personal loans.

Both strategies can be powerful tools when used wisely. Speaking with a financial professional before making a decision ensures you’re protecting both your financial future and your family’s legacy.