Life Insurance Cash Value: Taxable When Distributed

Life insurance is a crucial financial safety net for families, offering peace of mind and financial security in the event of a loved one's passing. While the death benefit is often tax-free, the cash value component of life insurance policies can be subject to taxation under certain circumstances. This complexity arises from the dual nature of cash value life insurance, which serves as both an insurance policy and a savings account. This savings element, or cash value, accumulates over time and can be accessed by the policyholder during their lifetime, providing a unique living benefit. However, understanding the tax implications of this cash value is essential for effective financial planning.

Withdrawing funds from cash value

Withdrawing funds from the cash value of your life insurance policy is a way to access your money early. However, there are some important considerations to keep in mind. Firstly, withdrawals may cause your policy to lapse, resulting in a loss of coverage. Secondly, while you can generally withdraw an amount equal to your total premium payments without owing taxes, you will likely owe income tax on any withdrawals that exceed this amount. This includes any gains, such as dividends or interest.

It is important to note that the rules regarding taxes on life insurance withdrawals can be complex and may vary depending on your specific situation and location. Therefore, it is always a good idea to consult with a tax advisor or financial professional before making any withdrawals from your life insurance policy to understand the potential tax implications.

Additionally, there may be other options for accessing the cash value of your life insurance policy, such as taking out a loan against the cash value or surrendering the policy, each with its own tax implications. By understanding the rules and carefully reviewing your options with a professional, you can make informed decisions about withdrawing funds from the cash value of your life insurance policy.

Surrendering your life insurance policy

You'll owe taxes on the amount you receive that's above the cost basis. If the cash surrender value you receive is higher than what you've paid in through premiums (cost basis), you can be taxed on the amount that is over what you've paid.

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

There are some scenarios when it may make sense to surrender your life insurance policy for cash:

• You've found a better deal: you may be able to qualify for a more affordable policy now compared to when you first took out your current one. For example, your health may have improved significantly, or you may have quit smoking.
• You can't afford the premiums: permanent life insurance is significantly more expensive than term life insurance. If the premiums are taking a big bite out of your income, you may be better off with a cheaper term life policy.
• You no longer need life insurance: there are instances when you simply may not need life insurance coverage anymore. For example, if no one depends on you financially, you may not need life insurance.
• You need a large amount of cash quickly: if you have a major expense to cover or a better investment opportunity but don't have any liquid assets to tap, surrendering a cash-value life insurance policy may be a good option, especially if your actual need for life insurance has diminished.

If you decide to surrender your life insurance policy, here's how to do it:

• 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 process for surrendering the policy and paying the cash surrender value.
• Fill out the 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 requested.
• 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. They 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 with 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.

Alternatives to surrendering your life insurance policy

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: you can borrow against your permanent life plan's cash value at low-interest rates and favorable terms. Policy loans have no due date, but interest accumulates on your outstanding loan balance. Your policy can lapse if the loan balance grows larger than your remaining cash value.
• Withdrawing from your cash value: withdrawing from your cash value lets you tap into your wealth without a loan and without surrendering your policy. However, withdrawals may trigger tax consequences if you withdraw investment gains. Withdrawals may also reduce your death benefit.
• Using your cash value to pay premiums: many permanent life insurance policies let you pay premiums with cash value once you accumulate enough. This can help you cut your life insurance costs while maintaining full coverage. However, if you drain your cash value, your policy can lapse.

Selling your life insurance policy

The process of selling a life insurance policy involves finding a buyer, meeting basic qualifications, and discussing your options with a licensed provider. You can sell your policy to a licensed life settlement provider, or you can go through a life settlement broker who will act on your behalf.

• Find an experienced life settlement provider or broker.
• 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.
• Authorize the provider to access medical records and contact the insurance company.
• Share your policy details with the provider.
• Wait for the underwriting process to be completed.
• Review the offer and explain next steps with your representative.
• Complete the closing process, which includes the transfer of ownership and the release of the settlement payment from escrow.

It's important to note that the amount of cash offered for your policy can vary greatly based on the specifics of your case. There is no standard settlement ratio or payout amount, so it's challenging to provide an accurate estimate without going through the evaluation process.

When considering selling your life insurance policy, it's recommended to speak with a financial advisor or tax expert. There may be tax implications, and you should also be aware of potential fees or commissions if you work with a broker. Additionally, selling your policy will result in the elimination of the death benefit for your beneficiaries.

Estate taxes on life insurance policies

One scenario is when the life insurance policy goes into an estate. If the policy does not have any named beneficiaries, the proceeds may be included in the deceased's estate. If the value of the estate exceeds the federal estate tax threshold, which was $13.61 million as of 2024, estate taxes must be paid on the amount above the limit. Some states also have their own estate or inheritance taxes, depending on the estate's value and location.

Another scenario is when the beneficiary of the life insurance policy passes away before the policyholder, or if the policyholder fails to name a beneficiary. In this case, the death benefit proceeds go to the policyholder's estate, making them taxable. Depending on the value of the estate and the state's tax laws, this can result in significant tax consequences.

To avoid estate taxes on life insurance policies, it is important to name a beneficiary other than your estate. Additionally, it is crucial to keep your beneficiary information up to date and review it periodically to ensure that your beneficiary is still alive and has not predeceased you.

It is also worth noting that the cash value of a life insurance policy may be taxable in certain situations. While the cash value of a life insurance policy grows tax-free, you may owe taxes if you withdraw more money than you have paid into the policy through premiums. This includes withdrawals, loans, or surrendering the policy. Consulting with a tax professional can help you understand the specific tax implications of your life insurance policy and how to minimize potential taxes.

Inheritance tax

If you are the beneficiary of a life insurance policy, you may be required to pay taxes on what you are paid. In general, the payout from a term, whole, or universal life insurance policy isn't considered part of the beneficiary's gross income and is not subject to income or estate taxes. However, there are some cases when a death benefit can be taxed.

If the payout is set up to be paid in multiple payments, the payments can be taxable. For example, an annuity paid regularly over the life of the beneficiary includes proceeds and interest, which can be subject to taxes.

If the policyholder has withdrawn money or taken out a loan, and the money withdrawn or loaned is more than the total amount of premiums paid, the excess may be taxable.

If you surrender your policy, any funds over your policy's cash basis will be taxed as regular income.

If the beneficiary isn't named in your policy, your life insurance benefits will go into a taxable estate. The first $11.7 million is not taxed at a federal level – this is the threshold. Anything above this amount is subject to being taxed. State regulations have a lower chance of exemption and vary depending on location.

To avoid paying any taxes on life insurance proceeds, a taxpayer will need to transfer ownership of the policy to another person or entity.

Frequently asked questions