Cashed-In Life Insurance: Taxable Income?

Whether or not cashed-in life insurance is considered income depends on your unique situation. Generally, life insurance proceeds are not considered taxable income, but there are some exceptions. For example, if the death benefit is paid in instalments, the interest accrued is taxable. If the policyholder names an estate as the beneficiary, the estate may be subject to estate taxes. If the insured borrowed money from their cash value life insurance policy, any outstanding loan balances can reduce the death benefit payout.

In most cases, the cash value of life insurance grows tax-free. However, there are instances where you may owe taxes on the cash value, such as if you take out a loan from your life insurance plan and the policy terminates before you've repaid it. If you cash out your policy, you can withdraw up to the total amount of the premiums you've paid without paying taxes, but withdrawing any gains, such as dividends, will be taxed as ordinary income.

Cashing out your policy

Cashing out your life insurance policy is a significant financial decision that can have implications on the death benefit and taxes. The best method depends on your individual needs and the type of policy you have. Here are some options to consider:

Withdrawal

You can withdraw a portion of the cash value of your life insurance policy. Withdrawing up to the amount of the total premiums you've paid into the policy is usually tax-free, as it's considered a return of your basis. However, withdrawing more than you've paid in premiums could be taxable as ordinary income. Withdrawals will also reduce your policy's cash value and death benefit.

Loan

You can take out a loan against the cash value of your life insurance policy. Loans are generally tax-free and don't require a loan application or credit check. The interest rates on policy loans are typically lower than on other types of loans. However, any unpaid loan balance and interest will be deducted from the death benefit that your beneficiaries receive. Taking a loan also won't affect your credit score.

Surrender

Surrendering your life insurance policy means cancelling the policy and taking the cash surrender value. This option will result in the termination of your coverage, and your beneficiaries will no longer be entitled to a death benefit. Surrendering your policy may also incur surrender fees and income taxes on any gains earned on the cash value portion of the policy.

Life Settlement

Selling your life insurance policy to a third party through a life settlement is another option. This involves selling the policy for a lump sum that is greater than the cash value but less than the death benefit. The buyer will then pay the policy premiums and receive the death benefit when you pass away. Life settlements can provide more cash than surrendering the policy, but there may be fees and income taxes associated with the sale. Additionally, the proceeds from the sale may disqualify you from certain programs such as Medicaid.

It's important to carefully consider the pros and cons of each option before making a decision. Cashing out your life insurance policy can provide quick access to funds, but it may also reduce your death benefit and have tax implications. It's recommended to consult a financial advisor to understand the specific consequences of each option for your situation.

Selling your policy

Selling your life insurance policy is a way to get money, but it can be complex and it doesn't always deliver great returns. Here are some tips on how to sell your policy and what to consider.

How to sell your life insurance policy

Selling your life insurance policy is somewhat complicated, so it's important to have a solid understanding of how it works and what to expect. Make sure you know what type of policy you have, how much coverage you have and how much cash value is in the account. Also, look into the rules and regulations for selling life insurance policies in your state.

You can sell your policy via a life settlement provider or a life settlement broker. Brokers can compare offers from various providers to find you the best one. Before providers give you an offer, they will likely ask you questions regarding your policy and medical records.

Tips for selling your life insurance policy

• Get to know the process.
• Consider hiring an independent advisor to assess your policy’s value.
• Find a reputable broker by interviewing several and asking questions like: What can you do to improve the offers I get? What is your commission structure? Are you licensed in your state? Are you willing to give discounts if I pay for medical expenses?
• Get multiple offers.
• Round up your paperwork, including your life insurance policy and medical records.

When to sell your life insurance policy

Selling your life insurance policy may only be a smart move in certain financial situations. For example, if you can no longer afford to pay your life insurance premium, selling the policy can relieve the burden of a monthly payment and put money back into your pocket. It may also be worth selling your life insurance policy if you need to cover a sizable unexpected cost, such as medical bills.

Tax considerations when selling your life insurance

When selling a life insurance policy, you may need to fill out IRS Form 1099-R. Selling your life insurance is effectively a distribution, which is why you may need this form. Be aware that selling your policy could increase or decrease your tax burden. For instance, you may have to pay income tax because when you sell a life insurance policy, the IRS considers part of the proceeds taxable income. The difference between the policy’s cash value and what you paid in premiums may be taxable.

Alternatives to selling your life insurance policy

• Accelerating the term.
• Taking a loan against the policy’s cash value.
• Surrendering the policy.
• Taking a personal loan.
• Withdrawing cash value.
• Replacing your policy.
• 1035 exchange.

Death benefit paid in instalments

When a person with life insurance passes away, their beneficiaries become eligible for the policy's death benefit. The death benefit is the coverage amount on the policy minus fees and, potentially, other costs. This is the main reason people purchase life insurance. When planning for difficult eventualities, people may use life insurance to safeguard against the financial consequences that their family or business may face when they die.

The death benefit is typically paid in a lump sum to beneficiaries, but there are other options. One such option is to receive the death benefit in instalments, also known as the specific income option. With instalments, the beneficiary receives the death benefit in batches over a set period of time. They continue to receive the payments until the death benefit runs out. Unlike annuities, instalments are not paid out of an investment account.

While life insurance death benefits paid in a lump sum are not subject to ordinary income tax, if the beneficiary receives the death benefit in instalments that include interest, then the interest will be taxable.

Death benefit payout options

• Annuity: The life insurance company puts the death benefit into an annuity investment account. Every year, the beneficiary receives a portion of the death benefit plus the interest it earns until the money runs out.
• Life income payout: The beneficiary may be able to receive the death benefit in guaranteed payments for the rest of their life. The amount received in each payment will be based on their age when they file the life insurance claim.
• Life income with period certain: This option allows the beneficiary to receive payments for a certain period, and for their beneficiaries to receive the remaining payments if they die before the period is up.

Why a death benefit claim might be denied

After a life insurance claim has been filed, the life insurance company will begin to review the claim and policy terms. If the policyholder has failed to make payments on the life insurance policy, or if their death falls under some cause or manner that is specifically excluded in their policy, these could be grounds for denying a death benefit claim.

Naming an estate as a beneficiary

If the policyholder names an estate as the beneficiary, the process becomes more complicated and can result in higher estate taxes for heirs. The proceeds left to a beneficiary may be taxable under the decedent's estate, both federally and on the state level in some cases.

Additionally, by listing an estate as the beneficiary, creditors may be able to access the death benefit to settle outstanding debts. This means that your loved ones could receive less money.

To avoid these issues, it is generally advised to name specific individuals, such as a spouse or adult children, as primary beneficiaries. This ensures that the death benefit is paid directly to them and is not subject to probate or accessible by creditors.

If you wish to include your estate in your beneficiary designations, it is recommended to consult with an estate planning attorney and financial advisor to ensure your belongings and the life insurance payout are distributed according to your wishes.

Borrowing against your policy

Borrowing against your life insurance policy can be a quick and easy way to get cash in hand when you need it. However, it is only possible to borrow against a permanent life insurance policy, such as whole life insurance or universal life insurance, which has a cash value. Term life insurance, on the other hand, is cheaper and does not have an expiration date, but it does not have a cash value and therefore cannot be borrowed against.

Borrowing against your life insurance policy can be done without a credit check and there is no formal approval process. The loan is also not recognised by the IRS as income and remains tax-free as long as the policy stays active. However, interest rates, although lower than those for personal loans and credit cards, will be added to the balance and will accrue if unpaid, which could cause the policy to lapse. In this case, the loan amount and any interest owed will be subtracted from the death benefit, leaving your beneficiaries with less money.

The amount you can borrow depends on the cash value of the policy and the rules set by the insurer. Generally, you can borrow up to 90% of the policy's cash value, but this may be lower depending on the insurer. It is important to note that it usually takes several years for the cash value to build up to a sufficient level to take out a loan.

Before borrowing against your life insurance policy, it is important to consider the potential disadvantages. These include the risk of losing your life insurance policy and incurring tax penalties if the loan is not paid back on time, as well as a reduced death benefit for your beneficiaries if the loan is not repaid before your death. Additionally, other benefits of the policy, such as an accelerated death benefit rider, may also be affected.

Frequently asked questions