By Kevin Luu, Co-Founder and Chief Learning Officer. Reviewed on 2026-09-30.
You can take money out of a cash-value life insurance policy (whole life, universal life or variable universal life) in six main ways: take dividends in cash, make a partial withdrawal, borrow against the policy, surrender it, exchange it for another contract under Section 1035, or, if the insured is seriously ill, draw an accelerated death benefit. For a policy that is not a modified endowment contract, withdrawals generally come out of your premiums first and are tax-free up to that amount, and policy loans are not taxed while the policy stays in force. A full surrender is taxed as ordinary income on anything above what you paid in, which for a California family in the top brackets can cost close to half of the gain.
Term life has no cash value, so none of this applies to it. If your only coverage is term through work or a private term policy, there is nothing to withdraw.
Why this question comes up for high-earning W-2 parents
Many physicians, scientists and tech employees in California and Washington bought a whole life policy early in their careers, often during residency or right after a first job offer. Ten or fifteen years later the household earns $900,000 or more, the kids are in elementary school, and the policy has built up six figures of cash value. The question becomes whether that money should fund a down payment, a Roth conversion year, a private school bill or simply go back into the family’s investment portfolio.
The answer depends on two things most families have never checked: the policy’s cost basis (roughly, the premiums you paid) and whether the IRS treats it as a modified endowment contract. Both are on a statement the insurer will send you on request.
The six ways to take money out, and how each is taxed
| Method | What happens | Federal tax (non-MEC policy) | Effect on the death benefit |
|---|---|---|---|
| Dividends in cash | Participating whole life policies may pay annual dividends you can take as cash | Not taxable until total dividends received exceed the net premiums you paid (IRS Pub 550) | Lower future growth, since dividends no longer buy paid-up additions |
| Partial withdrawal | You take part of the cash value out permanently | Generally basis first: tax-free up to your investment in the contract, taxable after that (IRC §72(e)(5)). A withdrawal that reduces the death benefit in the policy’s first 15 years can be taxed gain first, up to a limit (IRC §7702(f)(7)) | Reduced, sometimes by more than the amount withdrawn |
| Policy loan | The insurer lends you money using the cash value as collateral; interest accrues | Not treated as a distribution while the policy stays in force | Reduced by the loan balance plus unpaid interest |
| Full surrender | You cancel the policy and receive the cash surrender value | Proceeds above your cost are ordinary income, reported on Form 1099-R (IRS Pub 525) | Coverage ends |
| 1035 exchange | You move the cash value into a new life, annuity or qualified long-term care contract on the same insured | No recognized gain if the rules are met (IRS Pub 550) | Depends on the new contract |
| Accelerated death benefit | The policy pays part of the death benefit early because the insured is terminally or chronically ill | Excluded from income within the limits in IRS Pub 525 | Reduced by the amount paid out |
A seventh route, selling the policy to a third party in a life settlement, exists but is rarely a fit for parents in their 30s and 40s. Buyers pay most when the insured is older or ill, and the tax calculation differs from a surrender, so it needs a CPA’s review before any offer is accepted.
What “accumulated dividends” means on your statement
If your policy is a participating whole life contract, the statement may show “accumulated dividends” or “dividends on deposit.” That is money the insurer paid as dividends and you chose to leave with the company, where it earns interest. You can usually withdraw it without touching the base policy. Under IRS Pub 550, the dividends themselves are treated as a return of premium and are not taxable until they exceed your total net premiums, but the interest credited on dividends left on deposit is taxable interest income each year.
Worked example: a $1.1 million household in San Jose
Assumptions, for illustration only: a married couple filing jointly, one physician and one biotech scientist, W-2 income of $1.1 million, children aged 4 and 7, both parents under 59½. Taxable income before any insurance transaction is $900,000, and for simplicity California taxable income is assumed to be the same. In 2014 one spouse bought a whole life policy with a $10,000 annual premium. After 12 years of premiums, the cost basis is $120,000 and the cash surrender value is $165,000. Dividends have been used to buy paid-up additions, and the policy is not a MEC. The policy loan rate is assumed to be 6%.
Option A: surrender the policy
The taxable gain is $165,000 minus $120,000, or $45,000, taxed as ordinary income.
- Federal: the couple is already in the 37% bracket, which starts at $768,700 of taxable income for married couples filing jointly in 2026. $45,000 × 37% = $16,650.
- California: using the 2025 rate schedule (the latest the FTB has published), taxable income of $900,000 to $945,000 falls in the 11.3% bracket. $45,000 × 11.3% = $5,085. California has no lower rate for this kind of income, and SDI does not apply because it is not wages.
- Total: about $21,735, or roughly 48% of the gain. The gain may also count toward the 3.8% Net Investment Income Tax, so ask your CPA to confirm.
The same couple living in Washington in 2026 would owe the $16,650 federal tax and no state income tax. The surrender gain is ordinary income, not a long-term capital gain, so Washington’s capital gains tax generally does not reach it. Washington has enacted a 9.9% income tax on AGI over $1,000,000 starting January 1, 2028 (WA DOR), so a surrender planned for 2028 or later needs a fresh look.
Option B: withdraw $60,000
Because the policy is not a MEC, the first $120,000 out is generally a return of basis. A $60,000 withdrawal would normally be tax-free, and the remaining basis would drop to $60,000. The catch is the death benefit: on whole life, a withdrawal typically surrenders paid-up additions, which lowers both the cash value and the payout to the family. Because this policy is less than 15 years old, that reduction in benefits matters for tax too: under IRC §7702(f)(7), a cash distribution tied to a benefit reduction in the first 15 years can be taxed gain first, up to a “recapture ceiling” the insurer calculates. Ask the insurer how it will report the withdrawal on Form 1099-R before you request it.
Option C: borrow $60,000
A loan is not taxed while the policy stays in force. At an assumed 6% rate, interest is $3,600 in the first year. Left unpaid, the balance compounds to about $107,450 after 10 years ($60,000 × 1.0610). Every dollar of that balance comes off the death benefit. The larger risk: if the loan grows until the policy lapses, the outstanding loan is treated as a distribution, and the part above basis becomes taxable income in a year when you received no cash.
If the policy were a MEC
Distributions and loans from a MEC are taxed gain first. A $60,000 loan would make the first $45,000 taxable, and because the owner is under 59½, a 10% additional tax applies to that taxable amount under IRC §72(v): $4,500 on top of the income tax. A California owner would also owe the state’s 2.5% additional tax on early distributions from a modified endowment contract, another $1,125 (FTB Form 3805P, 2025).
How to tell whether your policy is a MEC
A policy becomes a modified endowment contract when premiums paid in the first seven years exceed a limit set by the “7-pay test” in IRC §7702A. This most often happens with policies funded heavily up front, including some designs sold as “infinite banking” or as a college savings alternative. Once a policy is a MEC, it stays one. Your insurer can confirm the status in writing, and you should get that confirmation before taking any money out.
The decision this family actually has to make
The tax is only half of the question. The other half is whether the family still needs the coverage. With children under 12, a surviving spouse would need to replace years of income, fund childcare and keep college plans on track. Before pulling cash from a permanent policy, work through these checks:
- Confirm the numbers. Request an in-force illustration, the current cost basis, the loan rate and the MEC status from the insurer.
- Confirm who owns the policy. If an irrevocable life insurance trust owns it, the cash value belongs to the trust, and the trustee, not the parents, decides what happens to it.
- Price the replacement coverage first. If you plan to surrender, have new term coverage approved and in force before cancelling. Health changes can make new coverage expensive or unavailable.
- Compare against a 1035 exchange. If the policy’s costs are high but you want to keep the basis and defer the gain, an exchange into a lower-cost contract may beat a surrender.
- Time any taxable gain. A surrender gain in a year with a large RSU vest lands at the top rate. A lower-income year, such as a sabbatical or a gap between jobs, can reduce the bill.
Common mistakes
- Treating a policy loan as free money. Interest accrues whether or not you pay it, and an unmanaged loan is the most common way these policies lapse with a tax bill attached.
- Surrendering before replacement coverage is in place, leaving young children underinsured.
- Assuming the cash value is the gain. Only the amount above your cost basis is taxable; ask for the basis figure rather than guessing.
- Taking cash from a MEC without realizing it, and paying income tax plus the 10% additional tax under age 59½.
- Forgetting that dividends left on deposit create taxable interest every year, even if you never withdraw them.
What to write down for your kids
A life insurance policy is a decision parents make on behalf of their children, and it is usually one the children never hear about. Whatever you decide, keep a one-page note: why you bought the policy, what it was meant to protect, why you kept, borrowed against or surrendered it, and what the numbers were. As Kevin Luu puts it: “Your kids will inherit your money. Will they inherit your judgment?” A short Decision Memo in your FamilyKnowledge® Library answers that question in a way a policy statement never will.
Frequently asked questions
Is money taken out of life insurance taxable?
It depends on the method. For a policy that is not a MEC, withdrawals are generally tax-free up to your cost basis, loans are not taxed while the policy is in force, and dividends are not taxed until they exceed your net premiums. A full surrender is taxable as ordinary income on the amount above your cost, and the insurer reports it on Form 1099-R.
Should we surrender a whole life policy we bought in residency?
Sometimes, but only after new term coverage is approved, and only after comparing the after-tax surrender value with keeping the policy or exchanging it. For a California family in the top brackets, the gain can be taxed at close to 50%. The right answer depends on the remaining coverage need, the policy’s internal costs and your health today.
Do outstanding policy loans reduce what our children receive?
Yes. The insurer subtracts any loan balance and unpaid interest from the death benefit before paying beneficiaries. A $60,000 loan that compounds at 6% for 10 years reduces the payout by about $107,450. If your policy was bought to protect young children, track the loan balance each year.
Next step
Ask your insurer for three things in writing: the policy’s cost basis, its MEC status and a current in-force illustration. With those numbers, the choice between keeping, borrowing, exchanging and surrendering usually becomes clear. For the related decisions, see how to get out of a whole life insurance policy, the rules for withdrawing from a universal life policy, withdrawing dividends from life insurance, and the pros and cons of infinite banking. Our estate planning and tax management pages explain how Age Five Family Office™ families review policies like this one as part of the Tax & Wealth Assessment.
This is general education, not individual advice. The right move depends on the family’s full picture, including coverage needs, other assets and the policy’s specific terms.
Kevin has advised high-income W-2 tech and biotech families since 2015, and leads the education-first Age Five Family Office from Brea, California.
Connect on LinkedIn → · About KevinThis is part of how we approach Estate Planning for high-income W-2 families at Bright Advisers.
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