Life Insurance Surrender: Taxable Or Not?

Life insurance can be a helpful investment, but some may feel they no longer need it and want to get their money back. Permanent life insurance policies can pay out a cash surrender value, allowing you to recoup some of your payments if you no longer need coverage. However, you may owe taxes in certain situations. This article will explore the topic of surrendering life insurance policies and the potential tax implications involved.

Surrendering a term insurance policy vs. a cash value policy

Surrendering a life insurance policy means cancelling the policy and receiving a payout from your insurance company. This payout is known as the cash surrender value.

Term life insurance and permanent life insurance are the two primary forms of life insurance. Term life insurance is typically less expensive but only lasts for a limited period, usually 10 or 20 years. Term life insurance policies do not build cash value, so there is no cash surrender value.

Permanent life insurance, on the other hand, builds cash value and is available in several forms, including whole life and universal life. Whole life insurance has a guaranteed premium and a guaranteed cash value. With whole life insurance, you pay the same premium each month, and your cash value grows at a guaranteed rate. Universal life insurance typically costs less than whole life insurance but does not provide the same guarantees. The cash value and cash surrender value of universal life insurance are based on current interest rates, which may fluctuate throughout the life of the policy.

When you surrender a term life insurance policy, you are essentially removing the monthly premium from your budget, but there is no cash payout. In contrast, when you surrender a permanent life insurance policy, you will receive a cash payout equal to the cash surrender value of the policy. This value is the amount of cash you've built up minus any surrender charges or fees.

It's important to note that surrendering a life insurance policy has tax implications. When you surrender a policy, you will receive the amount you paid in premiums back tax-free. However, if you receive more than you paid in total premiums, you may owe income tax on your earnings. Additionally, the cash surrender value of a life insurance policy is taxable if it is higher than the amount you've paid into the policy.

Before surrendering a life insurance policy, it's essential to consider the potential tax consequences and consult with a tax professional. There are also alternative options to accessing cash value, such as withdrawing or borrowing against the policy, which may be more suitable in some cases.

When is a death benefit taxable?

Death benefits are generally not subject to ordinary income tax. However, there are certain circumstances in which a death benefit may be taxable.

If a death benefit is paid to a beneficiary in installments that include interest, then the interest on that benefit will be taxable. Additionally, if the death benefit is paid to the deceased's estate, it may be subject to federal or state estate tax if the estate exceeds the estate tax exemption amount.

In the case of annuities, beneficiaries may have to pay income tax on death benefits. Death benefits from pensions may also be subject to taxation, though they are treated differently from benefits from life insurance policies.

It is important to note that any interest received from a life insurance policy is taxable and should be reported as interest received. If a policy was transferred 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 exceptions to this rule, and specific forms are required for reporting the taxable amount.

Surrendering a policy: taxable gain calculation

Surrendering a life insurance policy means you're terminating the policy. You may want to do this if you no longer want or need it, or if you want to get the cash value built up in the contract. This option is usually applied to permanent life insurance policies, such as whole life or universal life insurance.

When you surrender your policy, you are essentially cancelling it to get the cash surrender value. However, this is not the only way to get the cash surrender value. You could also borrow against the cash value or make a partial surrender.

The cash surrender value of a life insurance plan is the amount you will 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 you build cash value through regular premium payments.

The taxable amount, subject to ordinary income tax, is the difference between the cash surrender value minus the total premiums paid. This information can be found on your latest policy statement or by contacting your insurance company.

For example, if you have paid $50,000 in premiums over the life of your policy and the cash surrender value is $70,000, the taxable gain when surrendering your policy would be $20,000. The percentage you'll owe in taxes is whatever your current tax bracket is.

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

Let's go back to our previous example. If your cash value is $70,000, you paid $50,000, and your surrender fee is $5,000, the net surrender value (cash value – surrender fee) will be $65,000. To calculate the taxable gain, we then subtract the premiums paid ($50,000). That leaves you with $15,000 of taxable gain.

If you have an outstanding loan against your cash value, the insurance company will deduct the loan amount and any interest from the cash surrender value. This will reduce the amount of taxable gain you receive and, by extension, the amount of income tax you owe.

In the same example, if the cash surrender value on your policy 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, then the taxable gain would only be $10,000.

Treatment of outstanding loan balance

If you have an outstanding loan against your cash value, the insurance company will deduct the loan amount and any interest from the cash surrender value when you begin the surrender process. This will reduce the surrender value and, by extension, the amount of taxable gain you receive and the amount of income tax you owe.

For example, if the cash surrender value on your policy 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.

It's important to note that the treatment of outstanding loan balances upon surrender can vary depending on the insurance company and the specific policy. It's always a good idea to review your policy documents and consult with a tax advisor to understand the potential tax implications of surrendering your life insurance policy.

Surrendering a policy: tax implications

Surrendering a life insurance policy means you're terminating the policy. You don't want or need it anymore and would like to get the cash surrender value. This option usually applies to permanent life insurance policies, such as whole life or universal life insurance.

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

A policy's cash surrender value can depend 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 since the cash value will be larger, and you'll pay fewer fees.

The surrender of a life insurance policy is 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 considered taxable income. The amount you'll owe in taxes depends on your marginal tax rate for the year, often called your income tax bracket.

In the United States, cash from surrendering your life insurance is taxed as ordinary income, typically between 10% and 37%, depending on your income level. It's important to note that income taxes are usually higher than capital gains tax rates, so you'll likely owe more in taxes.

If you have outstanding policy loans, the insurance company will deduct the loan amount and any interest from the cash surrender value. The lower surrender value may reduce the amount of taxable gain and, by extension, the amount of income tax you owe.

To surrender your policy and receive the cash surrender value, you'll need to review your policy documents, speak with your insurer, fill out the necessary paperwork, and receive the cash surrender value. It is recommended to consult with a tax expert and financial advisor to ensure proper reporting and explore alternative investment options.

Before surrendering your life insurance policy, consider your financial goals and alternative options, such as borrowing against the policy or selling the policy, which may result in a larger cash payment.

Frequently asked questions