Financial Makeover: Cashing In

James' Insurance Needs

James presumably purchased the whole life insurance policy so that his family would have resources available to provide for their needs in the event of James' premature death. Given the family's outstanding debt and small savings, James' wife and children would likely face a financial hardship if James died anytime soon. Therefore, the life insurance coverage isn't something they should cancel too quickly.

However, one possible solution may be to cancel the whole life policy, replace it with a term insurance policy, and then determine what to do with the remaining cash. In this scenario, James should get the term life policy in place before he cancels the whole life policy in order to ensure that he still qualifies for affordable life insurance coverage.

Costs of Cancellation

Surrendering the whole life insurance policy could create taxable income for James. If James' CSV exceeds the total premiums he's paid over the life of the policy, the excess CSV will be taxed at James' marginal federal and state income tax rates (as opposed to the lower long-term capital gains tax rate). If this were the case, the income tax liability triggered by the policy cancellation could significantly reduce James' net cash value.

Therefore, before James decides to surrender the policy, he should contact the insurance company to determine whether he has any income tax exposure. James should also check to see if the policy has any surrender charges, which may also make canceling the policy cost prohibitive (surrender charges usually apply during the first few years of a whole life policy's existence).

Policy Loan: Another Solution

If surrendering the policy would create too heavy of a tax burden relative to the CSV or if replacing the whole life policy with a term insurance policy was too expensive (e.g., due to James' age, health condition, etc.), another alternative would be for James to borrow against the CSV.