Surrendering Va Life Insurance: Taxable Event Or Not?

Veterans Affairs Life Insurance (VALife) is a guaranteed acceptance product, meaning that the face amount of coverage takes effect two years after enrollment, provided that premiums are paid during the two-year period. If a veteran decides to cancel their VALife policy, they may receive a refund of their premiums paid if done within 31 days of enrollment. After two years, the policy begins to earn cash value, and the veteran can choose to receive the cash value of their policy or use it for extended term insurance.

Surrendering a life insurance policy may trigger tax consequences

Surrendering a life insurance policy means terminating the policy because you don't want or need it anymore. This option usually applies to permanent life insurance policies, such as whole life or universal life insurance, which accumulate cash value over time. This cash value is then factored into the surrender value.

When you surrender your policy, you are essentially canceling it to receive the cash surrender value. However, this may trigger tax consequences, resulting in a surprise tax bill. The Internal Revenue Service (IRS) considers the surrender of a life insurance policy a taxable event if the surrender value exceeds the premiums you have paid.

• Receiving more funds than the policy's cost basis: If the cash surrender value is greater than the total amount of premiums paid, the difference is considered taxable income by the IRS. The amount of tax owed depends on your marginal tax rate for the year, often referred to as your income tax bracket.
• Outstanding policy loans: If you have outstanding policy loans that exceed the policy's cost basis, the insurance company will deduct the loan amount and any interest from the cash surrender value. If the resulting lower surrender value still exceeds the amount of premiums paid, you will owe income tax on that amount.

How to receive the cash surrender value of your life insurance policy

If you decide to surrender your life insurance policy and receive the cash surrender value, here are the steps you need to take:

• Review your life insurance policy documents: Gather your policy documents, such as the contract, riders, amendments, and premium payment receipts. Look for information about cash surrender value, surrender charges, and other relevant terms.
• Speak with your insurer: Contact your life insurance provider's customer service to inform them of your intention to surrender your policy. They will guide you through their specific process for surrendering the policy and paying the cash surrender value.
• Fill out the necessary paperwork: Your insurer will provide you with the required forms, such as a policy termination form or a surrender request form. Complete these forms and provide all the requested information and documentation.
• Receive the cash surrender value: Your insurer will process your surrender request and determine the cash surrender value based on the policy's terms. They will then pay you that amount, usually via check or direct deposit.
• Consult with a tax expert and financial advisor: Receiving a large payout may trigger tax consequences, so it is essential to consult with a tax expert to ensure proper reporting. Additionally, consider consulting a financial advisor to explore the best options for investing or saving your funds.

Alternatives to surrendering your life insurance policy

Before surrendering your life insurance policy, consider the following alternatives:

• Borrow against the policy from the cash value: You can borrow against the cash value of your permanent life insurance policy at low-interest rates and favorable terms. Policy loans have no due date, but interest will accumulate on the outstanding loan balance. Ensure that the loan balance does not exceed your remaining cash value, as this could cause your policy to lapse.
• Withdraw from the cash value: Withdrawing from your cash value allows you to access your funds without taking out a loan or surrendering your policy. However, withdrawals may trigger tax consequences if you withdraw investment gains, and they may also reduce your death benefit.
• Use your cash value to pay premiums: Many permanent life insurance policies allow you to use your accumulated cash value to pay premiums. This can help reduce your life insurance costs while maintaining full coverage. However, if you deplete your cash value, your policy may lapse.

The taxable amount is the difference between cash surrender value and total premiums paid

Surrendering a life insurance policy may trigger tax consequences. 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 taxable amount is the difference between the cash surrender value and the total premiums paid.

The cash surrender value of a life insurance policy is the amount paid out to the policyholder when they cancel their plan. This is the savings component of most permanent life insurance policies, such as whole life and universal life. The cash surrender value is the total accumulated cash value, minus any prior withdrawals, outstanding loans, and surrender charges.

When you surrender a policy, you generally receive the premiums you have paid back tax-free. However, if you receive more than you paid in total premiums, the difference is considered taxable income by the IRS. The amount of tax owed depends on your marginal tax rate for the year, often referred to as your income tax bracket.

It is important to note that term life insurance policies do not accumulate cash value and, therefore, do not have a surrender value. Surrendering a term policy simply involves cancelling the policy, with no financial returns or tax consequences.

Before surrendering a life insurance policy, it is advisable to consult with a tax expert or financial advisor to understand the potential tax implications and explore alternative options for accessing the cash value.

Surrendering a term insurance policy vs a cash value policy

Surrendering a term insurance policy is very different from surrendering a cash value policy. Term life insurance does not carry any cash value, which means that there is no surrender value to the contract. If you cancel the policy, you won't get anything back. Surrendering a term policy simply means removing the monthly premium from your budget. However, you may be able to sell your term policy if it has a conversion feature.

On the other hand, cash value policies are more complex. Surrendering a cash value policy may provide you with the accumulated cash value, which can be taxable minus any surrender charges. However, to trigger tax charges, the cash value must be more than the amount of money you paid in premiums for the policy. Whole and universal policies accrue cash value, making them the most likely option for surrender. The cash surrender value of a life insurance policy is equal to the total accumulated cash value, minus prior withdrawals, outstanding loans, and surrender charges.

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 you've paid. Therefore, it is important to understand the math behind the numbers to get the best tax outcomes and talk with your tax advisor before surrendering the policy.

Ordinary income vs capital gains taxes

The difference between ordinary income and capital gains taxes is based on the type of income being taxed. Ordinary income is the income you earn from employment, interest, dividends, royalties, or self-employment. It is taxed at a standard rate, which can vary depending on your income level and tax filing status. For instance, in the US, federal income tax rates range from 10% to 37% of a person's taxable yearly income after deductions.

On the other hand, capital gains tax is applied to the profit made from selling a capital asset, such as stocks or real estate. Capital gains taxes are designed to encourage long-term investments and discourage short-term ones. There are two types of capital gains taxes: long-term and short-term.

Long-term capital gains taxes apply to assets held for over a year when sold and are taxed at preferential rates. For the 2024 tax year, the long-term capital gains tax rates in the US are 0%, 15%, or 20%, depending on income level and filing status.

Short-term capital gains taxes apply to assets held for a year or less and are treated as ordinary income, meaning they are taxed at the standard income tax rates.

When it comes to surrendering a life insurance policy, the cash received is generally taxed as ordinary income. This means that if you surrender your life insurance policy and receive a payout, you will likely owe taxes on the amount received, which can be a significant percentage of the surrender value.

Taxable gain calculation for surrendered policies

Surrendering a life insurance policy may trigger tax consequences, which primarily depends on the cash value of the policy and the total amount of premium paid. 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.

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. Accurate records for these numbers are essential for staying compliant with IRS taxation guidelines.

For example, if you have paid $50,000 in premiums over the life of your policy and the cash surrender value is $70,000, then 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 consider the 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.

It is important to note that surrender fees are not deductible on the policyholder’s tax return. These charges reduce the amount you receive from cashing out your policy and the amount of taxable gain you might pay, but they do not offer additional tax relief.

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. The lower surrender value may also reduce the amount of taxable gain you receive and, consequently, the amount of income tax you owe.

Using the previous 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.

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