Life Insurance Cash: Tax Penalty Or Tax Haven?

Life insurance is often seen as a reliable way to provide for loved ones after you're gone, and one of its biggest advantages is the tax relief it offers. Typically, the death benefit your beneficiaries receive isn't taxed as income, meaning they get the full amount to use for expenses like paying off debts, covering funeral costs or securing their future. However, there are some situations where taxes could come into play, and it's important to know when that might happen.

For example, if your loved ones choose to receive the life insurance payout in instalments instead of a lump sum, any interest that builds up on those payments could be taxed. That extra money from interest is considered taxable income, even though the original death benefit is not. Another exception occurs when a policyholder leaves the death benefit to their estate instead of directly naming a person as the beneficiary. If the estate's total value is large enough, it may trigger estate taxes, reducing what your loved ones ultimately receive.

Cash value life insurance, like whole or universal life, also has its own tax rules. Policyholders can generally borrow or withdraw money from the policy's cash value, and as long as they don't take out more than they've paid in, those withdrawals are usually tax-free. However, if there are unpaid loans against the policy, they will be deducted from the death benefit, meaning your beneficiaries get less.

If the policy is a modified endowment contract (MEC), taxes are different. For tax purposes, withdrawals are on a last-in, first-out (LIFO) basis. This means that all withdrawals are treated as taxable income until they cumulatively equal all interest earnings in the contract.

Withdrawing cash value

Most life insurance companies allow policyholders to take out loans and use their cash value as collateral. You are not required to pay back the money you borrow, but if you don't, the money gets subtracted from your death benefit, like with a traditional withdrawal. Even if you don't intend to repay the money you borrow, you're still responsible for paying interest. If you don't make the interest payments, the money gets taken out of your cash value. And, if your cash value runs out, your insurance company can terminate your policy.

It's important to carefully review the terms of your life insurance policy and consult with a financial advisor or tax professional before making any withdrawals to fully understand the potential consequences and ensure that you are making the best decision for your financial situation.

Surrendering a policy

Surrendering a life insurance policy means cancelling the policy and receiving its surrender value, which is the cash value minus any surrender fees. If you go down this route, the coverage ends, and your beneficiaries will not receive a death benefit when you die.

There are two main caveats to surrendering a policy. First, if your policy isn't very old, you may incur surrender fees that will reduce the amount of cash you receive. Surrender fees can be as high as 10-40% and can last about 10 to 15 years after you buy the policy. Second, the gain on your policy will be taxed as income. Death benefits are tax-exempt, but the cash received from surrendering a policy is taxable. Consult your tax professional before making any decisions.

When you surrender a policy, you must go through a formal cancellation process with your insurance carrier. You will typically get to keep the unused cash value from your policy, minus any surrender fees.

The surrender value of a policy is based on the portion of premiums that went into the cash value account, plus the interest rate paid or investment gains. From that, outstanding loans are subtracted, along with any surrender fees.

If you surrender your 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 withdrawals and policy loans, you can sign a lost policy release (LPR) to surrender or cancel your policy and use the cash any way you see fit. You can surrender part of the value in your policy while leaving the policy in force, or you can surrender the entire value and terminate the policy.

If you have the means, consider other options before using your life insurance policy for cash, such as borrowing against your 401(k) plan or taking out a home equity loan.

Policy loans

When taking out a policy loan, it is important to consider the potential impact on the death benefit. While the loan itself is not taxable, the death benefit will be reduced by the amount of the outstanding loan and any accrued interest. This means that the beneficiaries will receive a lower payout in the event of the policyholder's death.

Additionally, if the policy is surrendered or lapses with an outstanding loan, there may be tax consequences. In this case, the loan is treated as a distribution, and the policyholder will owe taxes on any gains made through investments. The taxable amount is calculated by subtracting the net premium cost from the amount received from the cash value of the policy.

It is also important to note that policy loans can have risks. If the loan is not repaid before the policyholder's death, the insurance company will reduce the death benefit by the amount that is still owed. Additionally, if the loan value exceeds the cash value of the policy, the policy may lapse and be terminated by the insurance company. In this case, the policyholder will owe income taxes on any investment gains, regardless of the amount of the loan.

Overall, while policy loans can provide access to cash, it is important to carefully consider the potential risks and tax implications before taking out a loan against a life insurance policy.

Interest on death benefit

The death benefit is the money paid out to beneficiaries when the insured person dies, and it is the primary reason people get life insurance. The benefit is usually paid out as a lump sum, but it can also be paid in installments or put into an annuity investment account.

The death benefit is generally not taxable, but there are some exceptions. If the beneficiary opts for monthly installments or annuities, the funds that have yet to be distributed will accrue taxable interest. If the beneficiary is the insured person's estate, taxes may also be owed. It is recommended that beneficiaries consult a tax advisor about their specific situation.

If the policy was transferred to the beneficiary for cash or other valuable consideration, the exclusion for proceeds is limited to the sum of the consideration paid, additional premiums paid, and certain other amounts. There are some exceptions to this rule.

Estate taxes

Life insurance proceeds are generally not considered part of the beneficiary's gross income and are therefore not subject to income or estate taxes. However, there are certain exceptions where a death benefit can be taxed. For example, if the payout is structured as multiple payments, these may be taxable. If the payout is set up as an annuity, the interest accrued by the annuity account may be subject to taxes.

If the policy has no named beneficiaries, the proceeds may be included in the deceased's estate, and if the value of the estate exceeds the federal estate tax threshold, estate taxes must be paid on the amount over the limit. Some states also assess inheritance or estate taxes, depending on the estate's value and the deceased's place of residence.

It is important to note that the death benefit of and cash value in a life insurance policy are often overlooked components of an estate for the purpose of calculating estate tax. Even if these benefits go to a child or other third-person beneficiary, they should be considered in attempting to minimise or eliminate estate tax.

Frequently asked questions