Cashing In Life Insurance: What's The Tax Impact?

Cashing in your life insurance policy can have tax implications, but it depends on your unique situation. Generally, the cash value of life insurance is not taxable as it grows within the policy. However, taxes may apply if you withdraw more than the total premium payments made. Surrendering or cashing out a policy may also incur taxes. If you take out a loan from your life insurance plan, it won't be taxable unless the policy terminates before you've repaid it. If you cash out your policy, you can withdraw up to the total of your premium payments without paying taxes, but any gains, such as dividends, will be taxed as ordinary income.

Surrendering a policy

Surrendering a life insurance policy means giving up the right to the death benefit. This can be done by signing a lost policy release (LPR) to surrender or cancel your policy, and the cash can then be used as you see fit.

There are two types of surrender: partial and full. A partial surrender involves surrendering part of the value in your policy while leaving the policy in force, whereas a full surrender involves surrendering the entire value and terminating the policy.

If you surrender the policy during the early years of ownership, when the value is relatively low, the insurance company will likely charge surrender fees, reducing your cash value. These charges vary depending on how long you've had the policy and the amount being surrendered. Some policies can levy surrender charges for many years after the policy is issued.

In addition, when you surrender your policy for cash, the gain on the policy is subject to income tax. Additional taxes could be incurred if you have an outstanding loan balance against the policy.

Although surrendering the policy can get you the cash you need, you're giving up the death-benefit protection afforded by the insurance. If you want to replace the lost death benefit later, getting the same coverage might be more complicated or more expensive.

Withdrawing cash

Types of Policies

Not all life insurance policies allow withdrawals. Certain types of cash value life insurance policies, such as universal and traditional whole life policies, may not permit withdrawals from the cash value. It is essential to review the terms and conditions of your specific policy to understand your options.

Basis in the Policy

Your basis in the policy, also known as the policy's cash value, is the amount of premiums you have paid minus any prior dividends or previous withdrawals. Withdrawals up to the amount of your basis are generally not taxable, as you have already paid income tax on those dollars. However, withdrawals exceeding your basis may be subject to income tax.

Modified Endowment Contracts

If your policy is considered a Modified Endowment Contract (MEC), the tax implications may be different. Withdrawals from an MEC may be taxed according to the rules applicable to annuities, with cash disbursements treated as coming from interest first and subject to income tax. Additionally, if you are under a certain age, there may be an early withdrawal penalty.

Surrender Charges

Even if you withdraw only up to your basis, surrender charges may apply. These charges vary depending on the length of time you have had the policy and the amount being withdrawn. To avoid surrender charges, you may consider taking a policy loan instead, using the cash value as collateral. However, interest on the loan is generally not tax-deductible.

Impact on Death Benefit

Withdrawals from your cash value may have unintended consequences on the death benefit. They can reduce the death benefit, the cash surrender value, or even increase premiums in certain situations. It is crucial to understand how your specific policy handles withdrawals to avoid any negative impact on the benefits for your beneficiaries.

Taxable Amount

The taxable amount of your withdrawal depends on the difference between the cash value and the amount you have paid in premiums. If the cash value is higher than the total premiums paid, you may need to pay income taxes on the excess amount. For example, if your cash value is $15,000 and you have paid $10,000 in premiums, you may be taxed on the additional $5,000.

Consulting Professionals

Due to the complexity of tax laws and the variability of life insurance policies, it is highly recommended to consult with a tax advisor or a Certified Public Accountant (CPA) before making any withdrawals. They can help you understand the specific rules and regulations that apply to your situation and guide you in making informed decisions.

Borrowing against a policy

Borrowing against a life insurance policy is a quick and easy way to get cash, but it is important to understand the specifics before doing so. Firstly, it is only possible to borrow against a permanent life insurance policy, such as whole life insurance or universal life insurance. These policies are more expensive than term life insurance but have no predetermined expiration date and can build cash value over time. This cash value can be borrowed against, but there are a few things to keep in mind.

The amount you can borrow is typically limited to a certain percentage of the policy's cash value, usually up to 90%. It is important to note that borrowing against your life insurance policy will reduce the death benefit if not paid off. The insurance company will add interest to the loan balance, which, if unpaid, can cause the policy to lapse. In this case, you may owe taxes on the borrowed amount. Therefore, it is crucial to make timely payments on the loan in addition to your regular premium payments.

Another thing to consider is that borrowing against your life insurance policy can tamper with the guarantee. Permanent insurance guarantees are based on certain assumptions, including regular premium payments and accumulating cash at a certain level. If you take out a loan, you may deplete the amount required to ensure the guarantee, and you may end up paying more money to cover the difference.

It is also worth noting that the loan is not recognised by the IRS as income, so it remains tax-free as long as the policy stays active and is not a modified endowment contract. However, if the policy lapses or is surrendered before the loan is repaid, the IRS will categorise the loan as taxable income.

In conclusion, while borrowing against a life insurance policy can be a convenient way to access cash, it is important to understand the potential risks and consequences, including reduced death benefits, policy lapse, and possible tax implications.

Policy loans

Here's how it works: you can borrow from the cash value of your policy, and this amount borrowed is generally not taxable as long as it doesn't exceed the sum of the insurance premiums you've paid. The loan typically accrues interest, which you may or may not be required to pay, depending on the policy. If you don't repay the loan and its interest, it will continue to reduce your policy's death benefit and could even cause the policy to lapse if the loan value surpasses the cash value.

If you surrender your policy or let it lapse, any outstanding loan balance will be deducted from your payout. Additionally, you will likely owe taxes on any gains made through investments above the total premiums paid. This means that even if your loan consumes the entire cash value, you may still face a significant tax bill upon surrendering or lapsing your policy.

To avoid this "tax bomb," it's crucial to carefully consider your options and consult with a financial advisor before taking out a policy loan.

Death benefits

However, there are a few exceptions to this rule. The type of policy you have, the size of your estate, and the way the benefit is paid out will dictate if your life insurance benefits will be taxed. If you opt for monthly installments rather than a lump sum, for example, the funds that have yet to be distributed will accrue taxable interest. Also, if you plan to name your estate as a beneficiary, you may owe taxes as well. It is a good idea to reach out to your tax advisor for more details on your specific situation.

In two specific circumstances, often referred to as a viatical settlement, meaning the sale of a life insurance policy by someone who is chronically or terminally ill, cash from selling your policy can be received entirely free from income tax. Suppose a life insurance policy on the life of an insured who is a "chronically ill individual" or a "terminally ill individual" is sold to a licensed life settlement provider. In that case, the sale price is treated as an amount paid under the policy by reason of the death of the insured. In other words, if you sell a policy on the life of an insured who meets the definition of a chronically ill individual or terminally ill individual, then the sale proceeds will be taxed as if the life insurance company had paid the death benefit.

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