Life Insurance Cash Withdrawals: Are They Taxable?

Life insurance is often taken out to provide peace of mind that loved ones will be financially secure in the event of the policyholder's death. But what happens when that policyholder needs to access the money in their lifetime? Is taking cash from life insurance taxable?

The answer depends on the type of policy and the method of withdrawal. Cash-value life insurance policies, such as whole life or universal life, allow policyholders to access the money that builds up within the policy. This can be done through a withdrawal, a loan, or by surrendering the policy and ending it.

Withdrawing up to the amount of the total premiums paid into the policy is generally not taxable, as it is considered a return of premiums. However, withdrawing any gains on the policy, such as dividends, may be taxed as ordinary income.

Taking a loan from a life insurance policy is also an option, and these loans are typically not taxable as long as the policy remains in force. However, if the policy terminates before the loan is repaid, the loan amount that exceeds the total premiums paid may be taxed.

Surrendering a life insurance policy may also result in taxes. The policyholder will receive the cash value of the policy minus any surrender fees, and the amount received above the total premiums paid may be subject to taxation.

Withdrawing more than the cost basis

Withdrawing more than your cost basis

If you decide to make a withdrawal from a universal life insurance policy, the IRS will only tax the portion that exceeds your cost basis (the total amount of premiums you’ve paid into the policy). The withdrawal amount up to your cost basis is tax-free, but anything above that is considered taxable income and will need to be reported.

Let’s say you’ve paid $50,000 in premiums (your cost basis) into your policy, and the cash value has grown to $80,000. If you decide to withdraw $30,000, none of it would be taxable because it’s below your cost basis. However, if you decide to withdraw the full $80,000, the first $50,000 is tax-free, but the remaining $30,000 would be considered taxable income and reported to the IRS.

It’s important to note that your policy’s cash value consists of your basis in the policy, plus any earnings. Because the earnings grow tax-deferred while inside the policy, they will be subject to income tax when you withdraw them. Withdrawals are generally treated as coming out of your policy basis first.

For example, if you have a cash value life insurance policy with a cash value of $18,000 and your basis in the policy is $12,000, a withdrawal of $12,000 or less will have no income tax consequences. However, if you withdraw $15,000 from the policy, you’ll have to pay income tax on $3,000 of it (at ordinary income rates, not at capital gains rates).

If your policy is a modified endowment contract (MEC), taxes are different. For tax purposes, withdrawals are on a last-in, first-out (LIFO) basis. This means that all withdrawals are treated as taxable income until they cumulatively equal all interest earnings in the contract.

Additionally, if you have a whole life insurance policy, be aware that withdrawals that reduce your cash value could cause a reduction in your death benefit—a potential source of funds your beneficiaries might need for income replacement, business purposes, or wealth preservation.

Surrendering the policy

Surrendering your life insurance policy means cancelling your coverage in exchange for a cash payout. This payout is called the cash surrender value (CSV). It is the amount accrued within the policy, minus any fees, outstanding loans, or interest owed.

The surrender of a life insurance policy is usually carried out when the policyholder's life circumstances change, and they no longer want or need the policy. Common reasons include adult children becoming financially independent, the passing of a spouse, financial difficulties, better investment opportunities, or unexpected expenses.

The process of surrendering a life insurance policy is relatively simple:

• Contact your insurance company to initiate the surrender process.
• Submit the required documentation, such as a surrender request form.
• Receive the CSV, usually via check or electronic transfer.
• Obtain confirmation of policy termination from your insurance provider.

It is important to note that surrendering a life insurance policy has several consequences. Firstly, you will no longer have life insurance coverage, and your beneficiaries will not receive the death benefit upon your death. Secondly, surrendering the policy can result in a financial loss, as the CSV is often lower than the total premiums paid. Additionally, there may be surrender fees and tax implications if there is an outstanding loan against the policy.

Before surrendering your life insurance policy, it is recommended to explore alternative options, such as borrowing against the policy, withdrawing from the cash value, or using the cash value to pay premiums. It is also advisable to consult with a financial advisor to consider the potential tax implications and explore other investment opportunities.

Policy lapse with outstanding loans

If you have a life insurance policy with cash value, you could withdraw or borrow cash from it. However, if you do not pay back the loan, your policy could lapse.

A policy lapse means that all benefits to the policyholder cease and the policy is terminated due to non-payment of the premium amount by the due date or even after the grace period. The grace period can vary depending on the insurer and policy type, ranging from 24 hours to 30 days.

If your policy has lapsed, you can apply for reinstatement within 30 days of the lapse without additional paperwork, underwriting, or health attestations. You will likely have to pay a reinstatement premium, which is larger than the original premium.

If your policy lapses with an outstanding loan, you will have to pay taxes on the money that came from interest or investment gains, even if you have an outstanding loan balance.

To avoid a policy lapse, you can put more money into the policy to pay down the loan. You can also pay the annual loan interest to prevent the loan from compounding further.

Interest on beneficiary proceeds

The death benefit itself is typically not taxed, but any interest that accumulates on those installment payments will be taxed as regular income. If the payout is spread over time, your beneficiaries should be prepared to report the interest on their taxes.

If you receive life insurance proceeds as a beneficiary due to the death of the insured person, you don't have to include it in your gross income and don't have to report it. However, any interest you receive is taxable and you should report it as interest received.

Policy loans

The loan is simply a personal loan from the life insurance company, for which the cash value of the insurance policy is collateral for the loan. The fact that the life insurance company has possession and controls the policy's cash value allows them to be confident that the loan will be repaid.

It is important to note that policy loans can reduce the death benefit paid to beneficiaries. If the loan is still outstanding when the policyholder dies, the insurance company will reduce the face amount of the insurance policy by the amount still owed, and the beneficiaries will receive a lower payout.

Frequently asked questions