Surrendering Life Insurance: Taxable Cash Or Tax-Free?

Life insurance is a valuable investment, but there may be times when you want to surrender your policy and recoup some of the money you've paid into it. If you surrender your life insurance policy, you'll receive a cash payout known as the cash surrender value. This value is based on the cash value of your policy, which is the component of a permanent life insurance policy that helps you build cash value over time through regular premium payments.

While surrendering your life insurance policy can provide you with a significant payout, it's important to be aware of the potential tax implications. The cash surrender value of a life insurance policy can be taxable in certain situations. Any amount you receive over the policy's basis, or the total premium payments you've made, may be taxed as income. Additionally, there are several other scenarios that may result in tax consequences when you surrender your policy.

To make an informed decision about surrendering your life insurance policy, it's recommended to consult with a tax expert and financial advisor. They can guide you through the tax implications and help you explore alternative options for accessing your cash value while maintaining your coverage.

Surrendering a life insurance policy

You'll owe taxes on the amount you receive that's above the cost basis.

If you no longer want or need your policy, you can sell it to a third party in what's known as a life settlement. You receive a one-time cash payment, often for more than the surrender value. The buyer assumes responsibility for the policy, including making the premium payments, and receives the death benefit when you die.

• The cash surrender value
• The cost of getting another life insurance policy
• Future financial goals

You don't have to surrender your life insurance policy to access your cash value. Some additional ways to use your cash value while maintaining your coverage include:

• Borrowing from your cash value
• Withdrawing from your cash value
• Using your cash value to pay premiums

When to surrender your life insurance policy

There are several scenarios when it may make sense to surrender a life insurance policy:

• You found a better deal
• You can't afford the premiums
• You no longer need life insurance
• You need a large amount of cash quickly

How to surrender your life insurance policy

If you'd like to surrender your policy and receive the cash surrender value, here's how to do so:

• Review your life insurance policy documents: Gather your policy documents, such as the contract, riders, amendments, and premium payment receipts. Look for wording about cash surrender value, surrender charges, and other surrender-related terms in your documents.
• Speak with your insurer: Inform your life insurance provider's customer service that you'd like to surrender your life insurance policy. They will guide you through the insurer's process for surrendering the policy and paying the cash surrender value.
• Fill out paperwork: Your insurer may give you a policy termination form, surrender request form, or similar paperwork. Complete these forms, providing all the information and documentation it asks for.
• Receive the cash surrender value: Your insurer will process your surrender request and determine the proper cash surrender value based on the policy's terms. It will then pay you that amount via check or direct deposit.
• Consult with a tax expert and financial advisor: Receiving a large payout could trigger tax consequences, so consult a tax expert to report everything properly. Furthermore, you may consider saving or investing your funds elsewhere. A financial advisor can help you pick the best place for these funds.

Withdrawing funds from cash value

Withdrawing funds from the cash value of your life insurance policy is a way to access your wealth without taking out a loan or surrendering your policy. However, there are some important considerations and potential tax consequences to be aware of.

Firstly, withdrawing funds from your cash value will almost certainly reduce the life insurance death benefit. In some cases, it may even cause the policy to lapse. Therefore, it is essential to review your policy documents and consult with your insurer before making any withdrawals.

When it comes to taxes, the Internal Revenue Service (IRS) generally taxes distributions from your cash value that are above the amount you have paid into your cash value through premiums. This means that if you withdraw more than you have contributed in premiums, the excess amount, typically derived from interest or investment gains, will be subject to income taxes. Your life insurance company can advise you on the taxable portion of your withdrawal.

To avoid taxes on your cash value, you can limit your withdrawals to the amount you have paid in premiums. Additionally, you can consider borrowing against your cash value, as loan proceeds are generally not taxable as long as your policy remains in force. However, keep in mind that interest will accumulate on any outstanding loan balance.

It is also important to note that if you withdraw funds from your cash value, you may need to pay taxes on any investment gains. This is because the earnings on your cash value are typically tax-deferred, meaning taxes are due when you withdraw the money.

Consulting with a tax expert and financial advisor before making any withdrawals is always recommended, as they can guide you on the potential tax implications and help you make informed decisions about your life insurance policy and finances.

Receiving a life insurance payout plus interest

Understanding the Basics

Firstly, it's crucial to know that life insurance proceeds are generally not considered taxable income. This means that if you receive a life insurance payout as a beneficiary due to the death of the insured person, you don't have to include it in your gross income for tax purposes. This is true for most states and situations.

Interest Income

However, any interest income you receive on top of the life insurance payout is typically taxable. This includes situations where you opt for monthly installments or annuities instead of a lump sum payment. The interest earned on the remaining benefit will be subject to income tax. For example, if you choose to receive $10,000 monthly payments from a $500,000 death benefit, you will owe taxes on the annual interest earned.

Policy Loans

If you have taken out a loan against the cash value of your life insurance policy, it is generally not taxable as long as the policy remains in force. However, if the policy terminates before you repay the loan, you may owe taxes on the loan amount. In this case, you will only pay taxes on the amount above the basis, which includes interest or investment earnings.

Cashing Out Your Policy

When you cash out your life insurance policy, you can generally withdraw up to the total amount of premiums you've paid without incurring taxes. However, if you withdraw any gains, such as dividends or investment earnings, these will be taxed as ordinary income.

Estate Taxes

In certain situations, life insurance proceeds may be subject to estate taxes. This typically occurs if the beneficiary passes away before the insured or if no beneficiary is named. If the death benefit proceeds go to the estate, they may be subject to estate taxes, depending on the value of the estate and the applicable state laws.

Lump-Sum vs. Installments

While receiving a life insurance payout in a lump sum is generally recommended due to its simplicity and flexibility, it's important to consider your financial situation. If you choose to receive the payout in installments, you can set the terms, such as the time period and amount of each payment. However, any interest earned on these installments will be taxable.

Seeking Professional Advice

Dealing with life insurance payouts and their tax implications can be complex. It is always recommended to consult with a tax expert or financial advisor to ensure you understand your specific situation and make informed decisions. They can guide you through the process and help you navigate any tax consequences.

Selling a life insurance policy

Selling your life insurance policy is known as a life settlement. This is when you sell your policy to a third party, known as a life settlement provider, and receive an immediate payment in return. The buyer then becomes the new owner of the policy and will receive the death benefit when the insured person dies.

Life settlement transactions can be handled by a life settlement broker or directly with a provider. Here is the general process for selling your life insurance policy:

• 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. It’s possible the buyer could resell the policy to someone else who will pay the premiums.
• You will occasionally have to check in with the buyer to confirm you're still alive.
• When you die, the owner receives your death benefit.

How much you’ll get if you sell your life insurance policy 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

Selling your life insurance policy is a way to make money, but there are some drawbacks:

• It can be tough to determine whether you’re getting a good price for a life settlement.
• The sales commissions involved can eat up a significant portion of a life settlement.
• You’ll likely have to pay taxes on at least some of the money you receive from a life settlement, while the death benefit of a life insurance policy is tax-free to your beneficiaries in most cases.
• 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.

Viatical settlements

If you're terminally ill with a life expectancy of less than two years, you may be eligible for a viatical settlement, which could provide a higher amount. In addition, viatical settlements typically aren't taxable.

Receiving a life insurance payout as a beneficiary

The death of a loved one is an emotional time, and dealing with a life insurance claim on top of that can be overwhelming. However, it is important to know that life insurance with a named beneficiary bypasses the probate process, so you do not have to wait to file a claim. Here is a step-by-step guide on what to do when receiving a life insurance payout as a beneficiary:

• Contact the insurance company: Get in touch with the insurance company as soon as possible after the policyholder's death. This can usually be done by phone or through their website. Have all the necessary information on hand, such as the policy number and the date of death.
• Fill out the required paperwork: The insurance company will provide you with a claims packet, which may include forms to fill out and documents to submit, such as a death certificate. Make sure to complete and submit all the necessary paperwork promptly to avoid delays in the claim process.
• Choose a payout option: Once the claim is approved, you will need to select how you would like to receive the life insurance payout. The most common option is a lump-sum payment, which provides immediate access to the full amount. Other options include annuity payouts, retained asset accounts, and interest-only payouts. Each option has its own advantages and tax implications, so consider your financial situation carefully before making a decision.
• Receive the payout: After submitting the completed paperwork, the insurance company will review and approve the claim. If all the documentation is in order, you will typically receive the life insurance payout within a month. However, there may be rare circumstances, such as policy purchase date, suspected foul play, fraud, or policyholder involvement in illegal activity, that could cause delays.
• Use the payout as needed: There are no restrictions on how the life insurance payout can be spent. Common uses include paying off a mortgage, saving for college tuition, paying down debt, saving for retirement, or creating an emergency fund.

It is important to note that life insurance payouts are generally income tax-free for beneficiaries. However, there may be tax implications in certain scenarios, such as if the payout accrues interest before being distributed or if the policyholder, insured, and beneficiary are three different people. Consult a financial advisor or tax professional for personalised guidance on any potential tax liabilities.

Frequently asked questions