Surrendering Life Insurance: Tax Implications And You

Surrendering a life insurance policy means terminating the policy because you don't want or need it anymore. This option usually applies to permanent life insurance policies, such as whole life or universal life insurance. When you surrender your policy, you receive a cash surrender value, which is the amount you are paid when you surrender your policy to your insurer. This amount is based on the policy's duration, growth, and assets. However, surrendering a life insurance policy may have tax implications in certain situations. For example, if the cash surrender value is more than the amount you paid in premiums, you may owe taxes on the difference. Additionally, if you have outstanding policy loans that exceed the policy's cost basis, you will owe income tax on the lower surrender value. It's important to consult with a tax expert and financial advisor before surrendering your life insurance policy to understand the potential tax consequences and make informed decisions.

Surrendering a term insurance policy vs a cash value policy

Term life insurance is a straightforward contract that covers a limited period, typically 10, 20, or 30 years. It does not accumulate cash value, and if you cancel the policy, you won't get anything back. Surrendering a term policy simply means removing the monthly premium from your budget. However, if you have a term policy with a conversion feature, you may be able to sell it instead.

On the other hand, cash value policies, such as whole life and universal life, are more complex. They build cash value over time, which can be useful if you want to take advantage of the cash value while you're still alive. Surrendering a cash value policy will provide you with the accumulated cash value, minus any surrender charges. However, this may trigger tax consequences if the cash value is more than the amount you paid in premiums.

When you surrender a cash value policy, you are essentially cancelling the policy to receive the cash surrender value. The cash surrender value is the amount of cash you've built up in the policy, minus any surrender charges or fees. The longer you've had the policy, the lower the surrender charges and the closer the cash surrender value will be to the cash value.

It's important to note that surrendering a life insurance policy, especially a cash value policy, can have tax implications. The Internal Revenue Service (IRS) considers the surrender of a life insurance policy a taxable event if the surrender value is more than the premiums you've paid. Therefore, it's crucial to consult with a tax advisor to understand the potential tax burden before surrendering your policy.

In summary, surrendering a term insurance policy simply means cancelling the coverage with no financial returns or tax consequences. In contrast, surrendering a cash value policy provides access to the accumulated cash value but may trigger taxes and surrender charges. The decision to surrender depends on your financial goals and whether you want to maintain the policy's coverage.

When is a surrender taxable?

Surrendering a life insurance policy is generally considered a taxable event if the surrender value is more than the premiums paid. This is because the IRS considers the difference between the surrender value and the total premium paid as taxable income.

The taxable amount is calculated by subtracting the total premiums paid from the cash surrender value. For example, if you have paid $50,000 in premiums and the cash surrender value is $70,000, the taxable gain would be $20,000. The percentage owed in taxes depends on your current tax bracket.

It is important to note that surrender fees, which are charges deducted by the insurance company if you surrender the policy before a specified number of years, will also impact the taxable amount. These fees usually start at 10% in the first year and reduce by 1% each year until they reach 0% in the tenth year.

Additionally, 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. This may reduce the amount of taxable gain and, consequently, the amount of income tax owed.

Term life insurance policies, which do not accumulate cash value, do not have surrender values, and therefore, surrendering them does not result in any financial returns or tax consequences.

Consulting with a tax advisor or financial advisor before surrendering a life insurance policy is recommended to understand the specific tax implications and explore alternative options.

Surrender fees

The amount of surrender fees varies depending on the insurance company and the length of time the policy has been in place. Some policies may impose surrender charges for many years after the policy is issued. Surrender fees can range from 10% to 20% but can be as high as 35% to 40% in some cases. It is important to carefully review the terms of your policy to understand the specific surrender fees that may apply.

For example, if your cash value is $70,000 and you are charged a surrender fee of $5,000, the net surrender value would be $65,000. If you have paid total premiums of $50,000, the taxable gain would be $15,000.

It is important to note that surrender fees are not deductible on the policyholder's tax return. While surrender fees reduce the amount of cash received when surrendering the policy, they do not provide any additional tax relief.

Outstanding loan balance

Treatment of Outstanding Loan Balance Upon Surrender

If you have an outstanding loan against your cash value, then the insurance company will deduct the loan amount and any interest from the cash surrender value when you begin that process.

The lower surrender value may also reduce the amount of taxable gain you receive and, by extension, the amount of income tax you owe.

Let’s look at an example.

If the cash surrender value on your policy is $70,000 and you have an outstanding loan balance of $10,000, then the net surrender value would be $60,000. If you’ve paid $50,000 in premiums, then the taxable gain would only be $10,000.

If you surrender your policy or your policy lapses, you must pay taxes on the money that came from interest or investment gains, even if you have an outstanding loan.

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

In addition to surrender charges, 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.

Withdrawing money or borrowing money from your life insurance policy can reduce your policy's death benefit. Surrendering the policy means you are giving up the right to the death benefit altogether.

Life insurance payout goes into a taxable estate

Life insurance death proceeds are generally not taxable with respect to income tax as long as the proceeds are paid out entirely as a lump-sum, one-time payment. However, if the beneficiary is anyone other than your spouse, the life insurance payout will be added to the value of your estate. This is only a concern if the total value of your estate exceeds the federal and state exemptions. In that case, any amount over the exemption is subject to estate and inheritance taxes.

Federal estate taxes apply to the value of your estate that exceeds $12.06 million per individual and is subject to a tax rate of up to 40%. State estate and inheritance taxes vary, with 17 states, plus Washington, D.C., having an inheritance or estate tax. The estate tax exemption amount varies by state, ranging from $1 million to $7 million, and tax rates can be as high as 20%.

If the life insurance payout goes into a taxable estate, there are a few ways to reduce the tax burden. One way is to set up an irrevocable life insurance trust (ILIT). By transferring ownership of the policy to the ILIT, the proceeds are not included as part of your estate. However, if the cash value of the life insurance policy is greater than the gift tax exemption, you may need to pay a gift tax when transferring ownership. Additionally, if you pass away within three years of transferring the policy, it will likely be considered part of your estate for tax purposes.

Another option is to choose a competent adult or entity to be the new owner of the policy. The new owner must pay the premiums, but you can gift them money to cover the cost. By transferring ownership, you give up the right to make changes to the policy in the future.

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