Life Insurance: Avoiding Capital Gains Tax?

Life insurance is a financial safeguard for beneficiaries upon the death of a policyholder. While the death benefit is typically tax-free, certain scenarios can trigger capital gains. For instance, if the policyholder sells their policy, surrenders it, or makes cash value withdrawals exceeding the cost basis, this may result in capital gains. Understanding these scenarios is crucial for policyholders to make strategic decisions and avoid unexpected tax implications. Additionally, the chosen payout method can influence how the funds are utilized and invested, potentially affecting future capital gains.

Life insurance policies can be sold

There are three ways to sell a life insurance policy: a life settlement, a viatical settlement, or a cash surrender. A life settlement involves selling your policy to a company that specialises in acquiring life insurance. A viatical settlement allows an individual with a terminal illness to sell their life insurance to a third party, often with the help of a broker. A cash surrender is only available with permanent insurance and involves returning the policy to the insurer and receiving a partial refund.

When selling a life insurance policy, it's important to consider the potential tax implications. The payment received from selling the policy may be taxable as income or capital gain, depending on the circumstances. It's recommended to consult a licensed tax attorney or financial advisor to understand the tax consequences. Additionally, selling a life insurance policy can impact the beneficiaries who would have received the benefit from the policy. It may result in a reduced inheritance or disrupt estate planning strategies.

Before selling a life insurance policy, it's essential to explore alternative options, such as policy loans, partial surrender, accelerated death benefits, conversion to a paid-up policy, or coverage reduction. These options can provide access to funds without completely giving up the life insurance protection or impacting the beneficiaries.

Surrendering a life insurance policy

The cash surrender value of a life insurance plan is the amount you’ll receive if you surrender your policy to your insurer. This amount is based on your cash value, the component of a permanent life insurance policy that helps you build cash value through regular premium payments.

The taxable amount, subject to ordinary income tax, is the difference between the cash surrender value minus the total premiums paid. For example, if you have paid $50,000 in premiums and the cash surrender value is $70,000, the taxable gain when surrendering your policy would be $20,000. The percentage you’ll owe in taxes is your current tax bracket.

Surrender fees are extra charges that the insurance company deducts from your cash value component if you surrender the policy before a specified number of years, usually around ten. They’re also normally on a sliding scale, reducing over time. While each company is different, surrender fees often start at 10% in Year 1, then reduce by 1% each year until dropping to 0% in Year 10.

If you have an outstanding loan against your cash value, the insurance company will deduct the loan amount and any interest from the cash surrender value. The lower surrender value may also reduce the amount of taxable gain and, by extension, the amount of income tax you owe.

Before surrendering your life insurance policy, consider your current financial situation, future financial needs, and current levels of risk. You could also borrow against the policy from the cash value, sell the policy, or consider reduced paid-up insurance to free yourself of paying premiums.

Partial withdrawals from a life insurance policy

When making a partial withdrawal, if the amount withdrawn is less than what has been paid into the policy, the policy owner will not be taxed on the withdrawal. However, if the withdrawal exceeds the cost basis (the total amount of premiums paid), the excess is treated as a capital gain and is taxed as ordinary income, not as long-term capital gains. Therefore, it is subject to the policyholder's regular income tax rate, which can be significantly higher.

It's worth noting that a partial withdrawal will lower the cash value of the policy, and while these funds do not typically need to be repaid, if the insured dies with an unpaid cash value balance, this amount will be deducted from the death benefit paid to the beneficiary. Additionally, there may be processing and administrative fees charged by the life insurance company.

Before making any partial withdrawals, it is recommended to consult a qualified insurance professional and/or tax professional to discuss all options and understand the potential tax consequences.

Tax implications of capital gains on life insurance

Life insurance is often considered an asset, and as such, it can be sold or surrendered. This means that capital gains tax may apply if you make a profit from selling your policy. Capital gains tax is a tax on the profits from the sale of an asset, and the rate of tax depends on how long you held the asset.

In the context of life insurance, if you sell your policy for more than the total amount of premiums you paid, the difference is considered a capital gain and is taxed as ordinary income. This means that the proceeds are taxed at your regular income tax rate, not the preferable long-term capital gains tax rates. Therefore, the tax rate can be significantly higher. It is important to note that this only applies if you sell a permanent life insurance policy that has a cash value component.

When you surrender a life insurance policy, any amount you receive above the total premiums paid constitutes a capital gain and is taxed as ordinary income. Similarly, if you make partial withdrawals from a cash value life insurance policy that exceed the cost basis, the excess is treated as a capital gain, even if the policy is still in effect.

It is important to accurately report capital gains from life insurance on your tax returns to avoid complications with the IRS. You should report these gains on IRS Form 1040 as income, not as capital gains.

There are strategies to minimize or defer capital gains on life insurance, such as using an irrevocable life insurance trust (ILIT) or leveraging the "step-up in basis" rule. Consulting a professional for tax planning services is advisable to navigate the complexities of life insurance and taxation.

Strategies for minimising capital gains on life insurance

Use a Life Insurance Trust

Creating an irrevocable life insurance trust (ILIT) can help avoid capital gains. Placing a life insurance policy inside an ILIT means the policyholder gives up ownership rights, preventing the proceeds from being part of their taxable estate. However, ILITs are complex and require careful planning, so professional guidance is recommended.

Leverage the "Step-Up in Basis" Rule

The "step-up in basis" rule allows the cost basis of an asset to be adjusted to its current market value when inherited. This rule can also apply to life insurance policies sold by the beneficiary and can lower capital gains. Beneficiaries can save substantial amounts in taxes by taking advantage of this rule.

Utilise 1035 Exchange for Life Insurance Policies

The 1035 exchange is a provision in the tax code that allows a policyholder to swap one life insurance policy for another without triggering a taxable event, deferring potential capital gains. However, the exchange must meet specific requirements to be valid, so it is essential to understand the rules or consult a tax professional.

Choose the Right Settlement Type

The type of settlement that is typically not taxable is a structured settlement for personal physical injuries or physical sickness. Proceeds from settlements for personal physical injuries or physical sickness are generally excluded from taxable income. However, other types of settlements, such as those related to employment disputes or property damage, may still be taxable.

Be Mindful of Partial Withdrawals

When making partial withdrawals from a cash value life insurance policy, it's important to be cautious about the amount and frequency. Withdrawals that exceed the cost basis are treated as capital gains, even if the policy remains in effect.

Frequently asked questions