Surrender Value Of Life Insurance: Taxable Or Not?

Life insurance can be a helpful investment, but some may feel they no longer need it and want to recoup some of their payments. Permanent life insurance policies pay out a cash surrender value, allowing you to get some of your money back if you no longer need coverage. However, you may owe taxes in certain situations. The Internal Revenue Service (IRS) considers the surrender of a life insurance policy a taxable event if the surrender value is more than the premiums paid. This article will explore the topic of life insurance surrender value and its potential tax implications.

When is the cash surrender value taxable?

The cash surrender value of a life insurance plan is the amount you receive if you surrender your policy to your insurer. This amount is based on the cash value, which is a component of a permanent life insurance policy that helps you build cash value through regular premium payments.

A policy's cash surrender value depends on the policy's duration, growth, and assets. Surrendering your policy earlier in the term may result in a lower cash surrender value since the cash value will be smaller, and you may owe surrender charges. However, if you surrender the policy later, you could receive a larger payout, as the cash value will be larger, and you'll pay fewer fees.

The cash surrender value of a life insurance policy can be taxable. Any amount you receive over the policy's basis, or the amount you paid in premiums, can be taxed as income. There are several scenarios that may result in potential tax consequences when you surrender your policy:

• You receive more funds than the policy's cost basis.
• You have outstanding policy loans that exceed the policy's cost basis.
• Your cost basis changed while you had the policy, such as reducing the death benefit or adding riders.

The IRS considers the surrender of a life insurance policy a taxable event if the surrender value is more than the premiums you've paid. The difference between the cash surrender value and the total premiums paid is subject to ordinary income tax.

It's important to consult with a tax expert or financial advisor before surrendering your life insurance policy, as the tax implications can be complex and depend on your unique situation.

When is the cash surrender value non-taxable?

The cash surrender value of a life insurance plan is the amount you receive if you surrender your policy to your insurer. This amount is based on the cash value of the policy, which is the component of a permanent life insurance policy that helps build cash value through regular premium payments.

The cash surrender value of a life insurance policy can be taxable. Any amount received over the policy's basis, or the amount paid in premiums, can be taxed as income. However, there are certain scenarios where the cash surrender value is non-taxable.

The cash surrender value is non-taxable if you withdraw up to the amount of the total premiums paid into the policy. In this case, the transaction is considered a return of premiums and is not subject to taxation. Additionally, if the policy is not classified as a modified endowment contract (MEC), cash-value withdrawals are generally not taxable up to the policy basis. An MEC is a life insurance policy where the funding exceeds federal tax law limits.

Furthermore, borrowed amounts from non-MEC policies are typically not taxable. There is no obligation to qualify financially for these loans, and the interest rates are usually favourable. However, it is important to note that loan balances may reduce the policy's death benefit, resulting in lower payouts to beneficiaries.

It is always recommended to consult with a tax expert and financial advisor before making any decisions regarding your life insurance policy, as there can be complex tax implications involved.

How to calculate the taxable amount?

The cash surrender value of a life insurance policy is generally considered a tax-free return of principal. However, any amount received over the policy's basis, or the total premiums paid, may be taxed as regular income. This includes any interest, dividends, or capital gains earned by the cash value of the policy.

To calculate the taxable amount, you need to determine the cash basis or the total amount of premiums paid into the policy. This amount is tax-free. Then, calculate the amount received over the cash basis, which will be taxed as regular income.

For example, if you have paid $450 a month into a whole life policy for 30 months, the first $13,500 of cash value will be tax-free. However, any dividends, interest, and capital gains earned during the policy will be taxed.

In addition, there may be surrender fees or charges associated with cancelling the policy early, which can reduce the cash surrender value. These fees can be as high as 10-30% and may result in you not even breaking even on the cash basis. Therefore, it is important to consider the potential tax implications and fees before surrendering a life insurance policy.

It is always recommended to consult with a tax expert or financial advisor to ensure that you report everything properly and make the most of the opportunity without unexpected tax bills.

How do surrender fees affect the taxable amount?

Surrender fees are extra charges that the insurance company deducts from your cash value component if you surrender your policy before a specified number of years, usually around ten. Surrender fees are typically on a sliding scale, reducing over time. While each company is different, surrender fees often start at 10% in Year 1, then reduce by 1% each year until they drop to 0% in Year 10.

Surrender fees affect the taxable amount of your cash surrender value. The taxable amount is the difference between the cash surrender value minus the total premiums paid. For example, if your cash value is $70,000, you paid $50,000 in premiums, and your surrender fee is $5,000, the net surrender value (cash value – surrender fee) will be $65,000. To calculate the taxable gain, you then subtract the premiums paid ($50,000), leaving you with a taxable gain of $15,000.

It's important to note that surrender charges are not deductible on the policyholder's tax return. While these charges reduce the amount you receive from cashing out your policy and lower the taxable gain, they don't provide additional tax relief.

Additionally, if you have an outstanding loan against your cash value, the insurance company will deduct the loan amount and any accrued interest from the cash surrender value. This lower surrender value may also reduce the taxable gain and, consequently, the amount of income tax you owe.

For instance, if your cash surrender value is $70,000 and you have an outstanding loan balance of $10,000, the net surrender value would be $60,000. If you've paid $50,000 in premiums, the taxable gain would be $10,000.

How is the treatment of an outstanding loan balance upon surrender?

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.

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 fee.

If you surrender your policy, you may end up with an outstanding loan balance. In this case, the taxable gain will still be based on the gross cash value (before repayment of the loan), which means it's possible that most/all of the cash value proceeds will be consumed by the tax liability for any gain.

If you have a universal life policy, the most straightforward path is to reduce the death benefit. Unlike changing the dividend option, this will require completing paperwork to substantiate the request – since reducing a death benefit is no small change, as once done it is typically permanent. The obvious downside to reducing the death benefit is that it literally reduces the death benefit – which means if the goal was to maximise the death benefit in the long run, this isn’t appealing. However, for those who are just trying to ensure the policy remains in force without lapsing and causing a tax bill, a death benefit reduction is an appealing option, as it reduces the ongoing Cost Of Insurance (COI) charges in the policy, which allows the cash value to grow faster (or at least decline more slowly), extending the crossover point where the policy loan potentially exceeds the available cash value (which would otherwise cause a lapse).

Another option for a universal life policy is to take a withdrawal from the cash value itself, and use the funds to pay down the loan balance. As long as the policy is not a Modified Endowment Contract (MEC), or subject to a “force-out” for overfunding under IRC Section 7702B – which can be confirmed with the insurance company – withdrawals from a universal life policy are treated as a basis-first return of principal and are not taxable (until all basis has been recovered). This provides a means to take a tax-free withdrawal from the policy (up to basis), and use it to immediately repay a portion of the loan.

In the case of whole life policies, where the death benefit and cash value structure is less flexible, there’s no way to take a non-taxable withdrawal from the policy, nor to just reduce the death benefit; however, it is possible to engage in a “partial surrender” of the policy, which liquidates a portion of the policy, returns a portion of the cash value, and reduces the death benefit accordingly. A partial surrender is a taxable event, but a partially taxable event that frees up cash to repay a life insurance loan may still be better than allowing the loan to outcompound the cash value, leading to a total surrender and a fully taxable event for the whole policy!

In addition to the potential of a partial surrender, it’s notable that a participating life insurance policy that has previously been purchasing PUAs can do a partial surrender of just the PUAs to free up cash to repay the loan. The “good” news of surrendering PUAs is that because that portion of the coverage is already paid up, its cash value tends to be high relative to the death benefit, which means the policyowner can give up less death benefit to get much more cash value out (at least compared to a partial surrender of the underlying policy itself). The “bad” news, though, is that a partial surrender of PUAs is still a taxable event; nonetheless, if the PUAs are available to liquidate, it’s a far more tax-efficient and cash-value-efficient path. For a policyowner who probably “should” have been using dividends to pay down the loan already, and was buying PUAs instead, this also provides a relatively efficient means to unwind the PUAs and redirect them back towards reducing or eliminating the policy loan.

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