Understanding Taxable Cash Value In Life Insurance Policies

Life insurance is a crucial financial safety net for your family in case of your untimely demise. While the death benefit is typically not taxable, there are certain situations where taxes may be levied on the cash value of your life insurance policy. Understanding these scenarios can help you make informed decisions and avoid unexpected tax burdens.

Firstly, it's important to distinguish between term life insurance and permanent life insurance. Term life insurance is a policy that is valid for a specific term or period, whereas permanent life insurance, such as whole life or universal life, includes a cash value component that can grow over time. This cash value is generally not taxed while it accumulates within the policy. However, taxes may apply when you withdraw funds, take out a loan, or surrender the policy.

In the case of permanent life insurance, withdrawals up to the total amount of premiums paid are usually tax-free. However, if your withdrawals exceed this amount, the excess is typically considered taxable income. Similarly, taking out a loan against your policy's cash value may not incur immediate taxes, but if the policy lapses or is cancelled with an outstanding loan balance, you will likely owe taxes on the amount above your cost basis.

Additionally, surrendering or cashing out your policy may result in taxes on the cash surrender value, which is the total cash value minus any loans and surrender fees. It is essential to carefully review the terms of your policy, as surrender fees can vary and sometimes remain in effect for several years.

Furthermore, if you choose to sell your life insurance policy, the proceeds may be subject to income tax or capital gains tax, depending on the sale amount. There are also tax implications if your policy is classified as a Modified Endowment Contract (MEC) due to overfunding. In such cases, withdrawals are taxed on a last-in, first-out basis, meaning you pay taxes on earnings before accessing your premiums.

To summarise, while life insurance proceeds are generally tax-exempt, certain actions, such as withdrawals, loans, policy surrender, or selling the policy, can trigger taxes. It is important to consult a tax advisor and carefully review the specifics of your policy to understand the potential tax consequences and make informed decisions.

Withdrawing more than your cost basis

For example, if you have a cash value life insurance policy with a cash value of $18,000 and a basis of $12,000, withdrawing $12,000 or less will not result in any income tax consequences. However, if you withdraw $15,000 from the policy, you will have to pay income tax on the $3,000 that exceeds your basis. It is important to note that withdrawals may also be subject to surrender charges and could result in a reduction of your death benefit.

To avoid taxes on withdrawals, it is recommended to stay below the cost basis, maintain a policy with a loan, or avoid overfunding the policy, as overfunding may lead to it being reclassified as a Modified Endowment Contract (MEC) by the IRS, which has different tax consequences. Additionally, delaying withdrawals until after the age of 59.5 can help avoid a 10% early withdrawal tax penalty.

Policy lapse with outstanding loans

A life insurance policy lapse occurs when a policyholder fails to pay the required premiums, resulting in the termination of policy benefits. This situation can have significant consequences for the insured and their beneficiaries, including loss of coverage, reinstatement challenges, increased premiums, loss of policy benefits, surrender charges, and tax implications.

If a policy with a cash value lapses or is surrendered, and the policyholder has taken out loans or made withdrawals, there may be tax consequences. The outstanding loan amount becomes taxable to the extent that the cash value (without reduction for the outstanding loan balance) exceeds the policyholder's basis in the contract.

To avoid a policy lapse, policyholders can set up automatic payments, use dividends to pay premiums, set up calendar reminders, maintain updated contact information, budget accordingly, and understand grace periods.

If a policy lapses, it may be possible to reinstate it, but this often comes with conditions and potential costs. Policyholders may need to provide evidence of insurability, pay all overdue premiums with interest, and undergo a new waiting period.

To avoid tax consequences and ensure uninterrupted protection for beneficiaries, it is crucial to take proactive steps to avoid a policy lapse.

• Reducing your coverage: If you no longer need as much coverage, you can reduce it to lower your premiums. However, this will also decrease the money your beneficiaries would receive if you die.
• Borrowing against your policy: If you have a whole life insurance policy with a cash value, you may be able to borrow against it to cover unexpected expenses or financial hardships.
• Surrendering your policy: If you no longer need or want your life insurance policy, you can surrender it to the insurance company in exchange for a cash payment. The amount of the cash payment will depend on the type of policy you have and the accumulated cash value.

It is important to carefully weigh the pros and cons of each option before making a decision and, if possible, discuss your life insurance options with a financial advisor or insurance professional.

Surrendering your policy

Surrendering your life insurance policy means cancelling it and receiving a lump sum payment from the insurance company. This payment is known as the cash surrender value and is calculated by subtracting any outstanding loans and surrender fees from the total cash value of the policy. Surrender fees vary by insurer but generally decrease the longer you've held the policy.

If you surrender your policy, you will no longer have life insurance coverage and your beneficiaries will not receive a death benefit when you die. Surrendering your policy should be a last resort, as there are other ways to access the cash value of your policy, such as withdrawing funds or taking out a loan.

When you surrender your policy, you will only need to pay taxes on the amount that exceeds the total amount of premiums paid into the policy. However, it's important to note that the gain on the policy is generally subject to income tax. Therefore, it's recommended that you consult a tax professional before making any decisions.

• You've found a better deal with a more affordable policy.
• You can no longer afford the premiums.
• You no longer need life insurance coverage.
• You need a large amount of cash quickly.

Interest earned on dividends

Dividends themselves are not taxable. They are considered a return of a portion of the premiums paid for a life insurance policy, for tax purposes. Insurance companies invest the premium payments they receive, and if they keep expenses down and their investments do well, they declare a dividend, which returns a portion of the surplus to policyowners.

Dividends are not guaranteed. They are dependent on the insurance company's earnings, and the calculation of how much of its earnings are distributed as dividends is not disclosed.

Selling your policy

Selling your life insurance policy is known as a life settlement. This is when you sell your policy to a third-party buyer for a cash payout. The buyer then becomes the new owner of the policy, taking on responsibility for maintaining premiums, and they will receive the death benefit when the insured person dies.

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: This is similar to a life settlement, but it is only available for people with a chronic or terminal illness and typically has a higher payout.

How to sell your life insurance policy

• Find an experienced life settlement provider.
• Meet the qualifying factors, such as owning a policy with a death benefit of $100,000 or more, and being over the age of 60.
• Take a detailed health questionnaire.
• Provide authorization for the provider to access medical records and contact the insurance company.
• Share your policy details with the life settlement provider, including a copy of the policy contract and a premium illustration.
• Wait for the underwriting process to be completed.
• Complete the closing process, which involves the transfer of ownership of the policy and all accompanying documentation.

Pros and cons of selling your life insurance policy

Pros

• End premium payments: Life settlements relieve you from the obligation to pay expensive premiums.
• Get more cash than the surrender value: Life settlements provide, on average, four times more money than the accumulated cash surrender value.
• Access to large amounts of cash: For those nearing or in retirement, a life insurance policy could represent an unexpected source of cash to supplement retirement income or pay down bills.
• Recoup money you’ve paid in: If you were to lapse a term policy, you’d get nothing back from the money you’ve paid in over the years. A life settlement can help you get some of your investment back.

Cons

• Potential tax liability: In most cases, you won’t owe income taxes on life settlement proceeds unless the settlement is greater than the total amount you’ve paid into the policy over the years.
• Ask about fees or commissions: If you work with a broker instead of going directly to a life settlement provider, the broker will take a commission.
• You may lose eligibility for financial assistance: If you currently receive Medicaid or other types of financial assistance, check with a financial advisor to understand eligibility rules before accepting a life settlement offer.
• Eliminates death benefit: Your beneficiaries will no longer receive the death benefit associated with the policy.

Frequently asked questions