Life Insurance Cash Value: Taxable Or Tax-Free?

Life insurance is a helpful investment for many, but some may feel they no longer need it and want to get some of the money they paid into the policy back. Permanent life insurance policies pay out a cash surrender value, allowing you to recoup some of your payments if you no longer need coverage. However, it's important to know that getting the cash surrender value may cause you to owe taxes in certain situations. This is because the cash value of a life insurance policy grows tax-free, but there are some instances where you may owe taxes on it. For example, if you withdraw more than the total premium you've paid, you may be taxed on the excess.

Cashing out your policy

If you need to cash out your life insurance policy, there are several ways to do so. However, it's important to understand the pros and cons of each option and consider the impact on your overall financial plan and the benefits for your dependents.

Withdrawals

You can withdraw money from the cash value of your policy. Withdrawals of up to the amount you've paid in premiums are generally tax-free, but withdrawals above this amount may be taxable as ordinary income. Withdrawals will also reduce the death benefit and could cause your policy to lapse if they exceed your cash value.

Loans

You can borrow money from the cash value of your policy. Loans are not taxable, and you are not obligated to repay them. However, the loan amount and interest will be deducted from the death benefit if you don't repay it. Loans can also reduce your policy's cash value, potentially causing it to lapse if insufficient premiums are paid.

Surrendering the Policy

You can surrender your policy and receive the full cash value, minus any surrender charges. However, this will terminate your coverage, and you will have to pay taxes on any gains.

Selling the Policy (Life Settlement)

You can sell your policy to a third party for a lump sum greater than the cash value but less than the death benefit. The buyer will then pay the premiums and receive the death benefit when you pass away. Life settlements can be a good option if you are older or have health issues, but there may be fees and tax implications.

Withdrawing from your cash value

There are a few things to keep in mind when withdrawing from your cash value. Firstly, withdrawals could cause your policy to lapse, resulting in a loss of coverage. Secondly, a withdrawal will typically result in a reduction in your death benefit. Finally, it is important to note that the withdrawal rules can vary by policy and are also regulated by federal tax rules.

To withdraw from your cash value, you can contact your insurance provider or log in to a member portal where your account information is located. It is also recommended to consult a financial advisor or tax professional to understand the tax implications and potential consequences of accessing your cash value.

• May not be an option within the first two years of the policy.
• Could result in taxable ordinary income if the withdrawal amount is above the cost basis.
• May be subject to a 10% federal tax penalty if the policy owner is under 59 1/2 years old.
• May not be able to put the funds back into the contract after withdrawal.

Borrowing from your cash value

Eligibility

To be eligible to borrow from your life insurance policy, you must have a permanent life insurance policy with a cash value component. This includes whole life insurance and universal life insurance policies. Term life insurance policies, which are designed to last for a limited period, typically do not have a cash value and therefore cannot be borrowed against. However, in some cases, a term life policy can be converted into a permanent policy, allowing you to build cash value and borrow against it.

Loan Amount

The amount you can borrow from your life insurance policy depends on the cash value that has accumulated and the terms set by your insurer. Typically, you can borrow up to a maximum of 90% of the policy's cash value. It usually takes several years for the cash value to build up to a level where you can take out a loan.

Interest and Repayment

Life insurance companies charge interest on the loan balance, and this interest can cause the loan amount to exceed the policy's cash value if left unpaid. This could lead to a lapse in your policy, resulting in additional tax consequences. It's important to make regular interest and premium payments to avoid this situation. Unlike traditional loans, policy loans do not have a fixed repayment schedule, but timely repayment is still crucial to avoid interest accumulation and potential tax issues.

Tax Implications

Borrowing against your cash value life insurance is generally tax-free as long as the policy stays active and you continue to make premium payments. However, if you fail to repay the loan or your policy lapses, you may owe taxes on the amount borrowed. It's essential to consult a tax advisor or financial professional to fully understand the tax implications before borrowing from your cash value.

Impact on Death Benefit

It's important to note that borrowing from your cash value will reduce the death benefit that your beneficiaries will receive. If you pass away with an outstanding loan balance, the insurance company will deduct the loan amount and any accrued interest from the death benefit payout. Therefore, borrowing from your cash value should be carefully considered, weighing the immediate financial needs against the potential long-term impact on your beneficiaries.

Surrendering a policy

Surrendering a life insurance policy means cancelling your insurance coverage in exchange for a lump-sum payout from your insurer. This payout is known as the cash surrender value and is calculated as the total cash value of the policy minus any surrender fees and taxes on earnings.

The cash value of a life insurance policy refers to the savings component of permanent policies, such as whole and universal life insurance. It is built up over time from excess premium payments and earnings.

Surrender Fees

Surrender fees typically range from 10-35% and are usually high in the early years of the policy, phasing out over time. Most policies have a waiting period of at least 15 years before you have the option to surrender. Surrender fees will reduce the amount of cash you receive, so it's important to review the fees outlined in your policy documents before making a decision.

Taxes

The gain on your policy will be taxed as income. While the cash value of a life insurance policy typically grows tax-free, the cash received from surrendering a policy is taxable. Consult a tax advisor to understand the specific rules and how they apply to your unique situation.

Alternatives to Surrendering

Before surrendering a policy, consider the following alternatives:

• Withdrawals: You can withdraw limited amounts from the cash value of your policy. Withdrawals are not taxable up to your policy basis, as long as your policy is not a modified endowment contract (MEC).
• Policy Loans: You can borrow money from your insurer using the cash value of your policy as collateral. Loan amounts from non-MEC policies are not taxable, and you are not obligated to qualify for the loan financially. However, loan balances generally reduce your policy's death benefit.
• Life Settlements: You can sell your life insurance policy to a person or life settlement company in exchange for cash. This option typically yields a higher payout than surrendering a policy.

Modified endowment contracts

A modified endowment contract (MEC) is a cash value life insurance policy that has lost its tax benefits because it contains too much cash. The Internal Revenue Service (IRS) reclassifies a life insurance policy as an MEC when it no longer meets the definition of a life insurance contract because the total collected premiums and cash value exceed federal tax-law limits. This permanent change can happen when you pay excess premiums in too short a period.

Criteria for an MEC

A life insurance policy is considered an MEC by the IRS if it meets three criteria:

• The policy was entered into on or after 20 June 1988.
• It must meet the statutory definition of a life insurance policy.
• The policy must fail to meet the Technical and Miscellaneous Revenue Act of 1988 (TAMRA) "seven-pay test".

The "seven-pay test" determines whether the total amount of premiums paid into a life insurance policy within the first seven years is more than what you'd need to pay it up in full for those seven years. Policies become MECs when the premiums paid to the policy are more than what was needed to be paid within that seven-year time frame.

Tax Implications of an MEC

The cost basis within an MEC and withdrawals from one aren't subject to taxation. Any cash value balance above what you paid in premiums counts as your interest gains. Unlike traditional life insurance policies, taxes on gains are considered regular income for MEC withdrawals. In the case of MECs, taxable interest is distributed first, rather than the tax-free principal.

In addition, the taxation of withdrawals under an MEC is similar to that of non-qualified annuity withdrawals. Withdrawals before the age of 59 1/2 may be subject to a 10% premature withdrawal penalty.

Another serious drawback of an MEC is that it removes the tax benefits for policy loans. In a traditional life insurance policy, you can borrow your cash value, including your earnings above premiums paid, without owing income tax. In an MEC, taking out your gains through a loan counts as a taxable withdrawal. The 10% premature penalty also applies before the age of 59 1/2.

Pros and Cons of MECs

Pros

• Offers a higher yield on low-risk funds than some alternatives.
• Allows for a smooth, tax-free asset transfer after the holder's death.
• The cash value can be borrowed against, although taxes apply.

Cons

• Erases tax advantages for withdrawals and loans.
• Cash value in the policy becomes less accessible.
• Borrowing may reduce the death benefit for heirs.

Frequently asked questions