Understanding Tax On Life Insurance Cash Value

Life insurance is a financial safety net that ensures your family is taken care of in the event of your passing. While the death benefit is typically tax-free, the cash value of a life insurance policy can be taxed under certain conditions. Cash value life insurance policies, such as whole life and universal life insurance, allow you to build up a savings component over time, which can be accessed through loans, withdrawals, or by surrendering the policy. Understanding the tax implications of these actions is crucial for effective financial planning.

Surrendering a cash value life insurance policy

When you surrender a cash value life insurance policy, you will receive the cash surrender value, which is the amount left over after any fees are deducted. This could include surrender charges, which are fees deducted by the insurance company for cancelling the policy early. The surrender charge can start as high as 10% to 35% of your policy's cash value, and it typically decreases over time. Most policies end the surrender charge after 10 to 15 years, at which point your cash surrender value equals your cash value.

The cash surrender value of a life insurance policy is generally taxable if it exceeds the amount you have paid in premiums. This is because the cash value component of a life insurance policy can grow over time, and the growth may be taxable as income. Therefore, if you surrender your policy and receive a payout that is larger than the total premiums you have paid, you may owe income tax on the excess amount.

It's important to carefully consider the potential tax implications before surrendering a cash value life insurance policy. Consulting with a tax expert or financial advisor is recommended to ensure you report everything properly and make informed decisions about what to do with the funds.

Additionally, it's worth noting that surrendering your life insurance policy means giving up your life insurance protection. Your beneficiaries will no longer receive a death benefit when you pass away, so it's crucial to weigh the benefits of accessing the cash value against the loss of coverage.

Withdrawing cash from a life insurance policy

Types of Life Insurance Policies

There are two main types of life insurance policies: term life insurance and permanent life insurance. Term life insurance is purely an insurance policy that provides coverage for a limited time and has no cash value component. On the other hand, permanent life insurance, such as whole life insurance, universal life insurance, variable universal life insurance, and indexed universal life insurance, offers both a death benefit and a cash value component. The cash value in a permanent life insurance policy grows over time as you pay your premiums.

Withdrawing Cash from Permanent Life Insurance

If you have a permanent life insurance policy, you can withdraw cash from the policy's cash value. However, it is important to note that withdrawals may be subject to taxes and penalties. Here are some common ways to withdraw cash from a permanent life insurance policy:

• Full Withdrawal: You can surrender your policy and withdraw the full cash value, minus any surrender fees. This option cancels your coverage, and your beneficiaries will not receive a death benefit. Withdrawals above the amount you've paid into the policy may be taxed as income.
• Partial Withdrawal: You can withdraw part of the cash value without cancelling the coverage. This option allows you to access cash while maintaining the policy. However, your beneficiaries will receive a reduced payout when you pass away. Withdrawals up to the amount of premiums paid are typically tax-free.
• Policy Loan: You can borrow against the cash value of your policy. This option allows you to access cash with no credit check and a flexible repayment schedule. Interest rates on policy loans are usually lower than those charged by other financial institutions. If you don't repay the loan before your death, the amount you owe, including interest, will be deducted from the death benefit.

Tax Implications

The tax implications of withdrawing cash from a life insurance policy depend on the type of policy and the amount withdrawn. Here are some key points to consider:

• Withdrawals up to the amount of premiums paid are generally tax-free.
• Withdrawals exceeding the amount of premiums paid may be taxed as income.
• If you surrender your policy and receive more money than you've paid into it, the gain may be subject to income tax.
• Policy loans are not taxable as long as the policy remains active. However, if the policy lapses or is cancelled before the loan is repaid, the unpaid loan amount may be treated as taxable income.

Alternatives to Withdrawing Cash

Before withdrawing cash from your life insurance policy, consider exploring alternative options to meet your financial needs:

• Personal loans: These can provide quick access to cash with potentially lower interest rates than credit cards, especially if you have good credit.
• 0% intro APR credit cards: Using a credit card with a 0% introductory interest rate can help you avoid paying interest on your purchases if you pay off the balance within the promotional period.
• Home equity loans: Tapping into the equity in your home can provide a lower interest rate, but you risk losing your home if you can't make the payments.
• Credit card cash advance: This option is typically expensive due to high fees and interest rates, and it can negatively impact your credit scores.

In conclusion, withdrawing cash from a life insurance policy can provide much-needed funds during financial difficulties. However, it is important to carefully consider the implications and tax consequences of each option before making a decision. It is always recommended to consult with a financial advisor or tax professional to ensure you understand the full impact of withdrawing cash from your life insurance policy.

Taking a loan from a life insurance policy

If you have a permanent life insurance policy, you can use its cash value as collateral to take out a loan. There is no approval process or credit check required, and you can use the loan for anything you want. The interest rates on life insurance loans are typically lower than those for personal loans or credit cards, ranging from 5% to 8%. Additionally, there is no strict repayment schedule, but it is in your best interest to pay back the loan as soon as possible to avoid accruing more interest.

While life insurance loans are generally tax-free, there are situations where taxes may apply. If you do not repay the loan and your policy lapses or ends before you've repaid it, you may owe taxes on the amount borrowed. In such cases, you will only be taxed on the amount above the policy's basis, which is the interest earned. Therefore, it is important to consult a financial advisor to understand the tax implications before borrowing from your life insurance policy.

Selling a life insurance policy

There are two types of life settlement:

• Life settlement: The sale of a life insurance policy to a third-party buyer. The main eligibility requirements are the person’s age, policy value, policy type, and health status.
• Viatical settlement: Similar to a life settlement, but only available for people with a chronic or terminal illness and typically has a higher payout.

How to sell your life insurance policy

You can sell your life insurance policy via a life settlement provider or a life settlement broker. Here is the general process:

• Provide the details of your life insurance policy, along with medical records.
• If you’re using a broker, they will shop the policy to potential buyers. Buyers will calculate your life expectancy based on your medical records.
• If you receive an offer, you can sell your policy.
• You will make the buyer the new policy owner, and the buyer will start paying your premiums.
• Occasionally, the buyer may ask you to confirm you're still alive. For example, they might periodically send you a postcard that you need to sign and return.
• When you die, the owner receives your death benefit.

How much you’ll get depends on your life expectancy, the life insurance face amount, and how much the buyer expects to pay in premiums while you’re alive. The offer is generally more than the cash surrender value of your policy, but less than the death benefit your beneficiaries would receive if you didn’t sell the policy.

When you receive more money from the life settlement than you paid in premiums, you may owe income or capital gains tax on the difference.

Potential pitfalls of life settlements

There are some drawbacks to selling your life insurance policy:

• It can be tough to determine whether you’re getting a good price.
• The sales commissions involved can eat up as much as 30% of a life settlement.
• You’ll likely have to pay taxes on at least some of the money you receive.
• If family members still rely on you financially, they’ll be without the safety net of the life insurance death benefit when you die.
• If you use public assistance, a life settlement could make you ineligible.

Alternatives to life settlements

If you no longer need life insurance, you might be able to surrender your permanent policy. When you do this, you’re essentially canceling your policy in exchange for a lump sum of money. The amount you get is based largely on your policy’s cash value amount. While surrendering a policy may be faster and easier than selling it, you’ll likely get more cash from a life settlement.

Naming your estate as a beneficiary

When you name your estate as the beneficiary, the death benefit becomes part of your taxable estate. This means that it will be subject to estate taxes, which can reduce the amount your loved ones ultimately receive. In the United States, this generally only affects high-net-worth individuals, but some states have lower thresholds for estate taxes.

Additionally, if you name your estate as the beneficiary, the funds will first go through probate court, where a judge will determine what debts you owe. Creditors will then be able to collect repayment from your estate, further reducing the amount available for your loved ones.

On the other hand, when you name specific individuals, such as your spouse or adult children, as beneficiaries, the death benefit is paid directly to them and does not have to go through probate. This means that creditors cannot collect the death benefit to repay your debts, and your loved ones can receive the full amount.

It is important to keep in mind that if you do not name a beneficiary at all, most life insurance policies have a default order of payment. For individual policies, the death benefit will typically be paid to the owner of the policy or their estate. For group insurance policies, the order usually starts with the spouse, followed by children, then parents, and then the estate.

Therefore, it is generally advisable to name specific individuals as beneficiaries on your life insurance policy, rather than your estate, to ensure that your loved ones receive the maximum benefit.

Frequently asked questions