Universal Life Insurance Cash Value: Taxable Or Not?

Universal life insurance is a type of permanent life insurance that offers lifetime coverage as long as you continue to pay your premiums. It also has a cash value element that grows over time and can be accessed while the policyholder is still alive. But is the cash value of universal life insurance taxable? The answer depends on various factors.

Withdrawing money from a universal life insurance policy

When considering withdrawing money from a universal life insurance policy, it's important to understand the potential tax implications. Withdrawals up to the total amount of premiums paid are generally tax-free. However, withdrawals that exceed this amount may be subject to taxes. Additionally, withdrawals can reduce the death benefit and may cause the policy to lapse if the cash value becomes too low.

Another option for accessing cash from a universal life insurance policy is to take out a loan against the policy's cash value. Policy loans are not taxable, and the interest rates are often lower than those for personal loans. However, if the loan is not repaid, it will be deducted from the death benefit, and any unpaid interest may cause the policy to lapse.

Alternatively, policyholders can choose to surrender or cash out their policy, receiving the cash value minus any surrender fees. However, this option will result in the loss of life insurance coverage, and the gain on the policy may be subject to income tax.

It's important to carefully consider the potential consequences of each option before making a decision. Consulting with a financial advisor or tax professional can help individuals understand the full implications of withdrawing money from a universal life insurance policy and make an informed choice that aligns with their specific needs and circumstances.

Borrowing money from a universal life insurance policy

Eligibility and Requirements

To be eligible for a loan against your universal life insurance policy, you need to have sufficient cash value built up in your policy. The minimum amount required varies by insurer, and it may take several years for a new policy to accrue enough value. Once you have enough cash value, you can use it as collateral to borrow money from your insurance company.

Advantages

Borrowing against your universal life insurance policy offers several benefits:

• No credit check required: You are essentially borrowing your own money, so there is no need for a formal credit check.
• Low-interest rates: Interest rates for life insurance loans are typically lower than those for personal loans or credit cards, ranging from 5% to 8%.
• Flexible repayment options: There is no strict repayment schedule, and you can pay back the loan when it suits your budget and cash flow.
• Cash value continues to grow: Your policy's cash value serves as collateral, so it continues to earn interest even while you have a loan outstanding.

Disadvantages

There are also some potential drawbacks to consider:

• Minimum cash value required: It may take time to build up enough cash value in your policy to qualify for a loan.
• Borrowing amount limited: You can usually only borrow up to a certain percentage of your cash value, typically around 90% to 95%.
• Reduced death benefit: If you don't repay the loan before your death, the outstanding balance will be deducted from the death benefit paid to your beneficiaries.
• Risk of lapse: If the loan and interest exceed your cash value, your policy could lapse, resulting in a loss of coverage.
• Potential tax consequences: If your policy lapses or is surrendered with an outstanding loan balance, you may owe taxes on the amount borrowed.

Steps to Take Out a Loan

If you decide to borrow against your universal life insurance policy, here are the steps you can follow:

• Contact your insurance agent or financial advisor to discuss your loan options, interest rates, and repayment terms.
• Verify that your policy includes a loan provision and that you have accumulated enough cash value to borrow the desired amount.
• Review the terms of your policy, including maximum and minimum loan amounts, interest rates, and repayment options.
• Seek tax advice if needed, especially if you are concerned about the potential for your policy to lapse.
• Complete the insurer's loan application form and review and sign the loan agreement.
• Receive the funds, which will typically be deposited into the account used for premium payments.

In conclusion, borrowing against a universal life insurance policy can be a useful strategy in certain situations. However, it's important to carefully consider the advantages and disadvantages and seek professional advice to ensure it aligns with your financial goals.

Surrendering a universal life insurance policy

There are a few things to consider before surrendering a universal life insurance policy:

• Tax implications: While the cash value of life insurance is generally not taxable, surrendering a policy may incur taxes on withdrawals, loans, or surrenders that exceed the total premium payments made. It is important to understand the specific rules and consult a tax advisor for guidance.
• Fees and charges: Insurance companies may deduct surrender charges and other fees from the cash value payout. The surrender charge can start as high as 10% to 35% of the policy cash value and usually decreases over time. Most policies end the surrender charge after 10 to 15 years.
• Loss of coverage: Surrendering a policy means losing your life insurance protection. Your beneficiaries will no longer receive a death benefit when you pass away.
• Alternative options: Before surrendering a policy, consider other options such as reducing the death benefit, exchanging the policy for a different type of life insurance product, or keeping the policy and making changes to it.
• One expert suggests keeping the policy but dropping the face value and stopping premium payments. This will save on annual premiums, and the policy value will increase every year.
• Another expert calculates that the internal rate of return on continued premiums until the policyholder's life expectancy is favourable. However, they acknowledge that the increasing costs will eat away at the cash value over time.
• A third expert suggests surrendering the policy, calling it a "wasting asset" that will only continue to incur higher costs. They recommend finding a better home for the cash.
• A fourth expert is of two minds: they suggest either surrendering the policy for a better product or keeping and maximizing the policy by taking advantage of the guaranteed yield.

In conclusion, the decision to surrender a universal life insurance policy depends on various factors, including the policyholder's financial situation, life expectancy, and the performance of the policy. It is important to carefully consider all options and consult with a financial advisor or tax professional before making any decisions.

Modified endowment contracts

A modified endowment contract is a life insurance policy that has been altered to provide more cash value accumulation than a traditional policy. This is done by increasing the premiums paid into the policy. As a result, the cash value of the policy grows faster, providing a larger source of funds that can be borrowed against or withdrawn. However, this also means that the policy is now primarily a financial investment rather than a life insurance policy. Therefore, the tax benefits associated with traditional life insurance policies no longer apply, and the earnings portion of any withdrawals, loans, or surrenders becomes taxable.

It's important to note that a modified endowment contract is different from a traditional endowment policy. A traditional endowment policy is designed to pay out a lump sum after a certain period, usually to cover a specific expense such as education costs or retirement. In contrast, a modified endowment contract is a permanent life insurance policy that has been modified to provide increased cash value accumulation.

To determine if a policy is a modified endowment contract, the IRS uses a test called the "7-pay test." This test calculates the amount of money that would be needed to fund the death benefit of the policy over seven years. If the total premiums paid over the first seven years of the policy exceed this amount, then the policy is considered a modified endowment contract.

It's worth noting that not all life insurance policies can become modified endowment contracts. Certain types of policies, such as term life insurance, do not accumulate cash value and, therefore, cannot be modified in this way. Additionally, even permanent life insurance policies that do accumulate cash value, such as whole life or universal life insurance, may have restrictions on how much the premiums can be increased, limiting their potential to become modified endowment contracts.

Tax implications for beneficiaries

Universal life insurance is a form of permanent life insurance with an investment savings element, loan options, and flexible premiums. It is a good way to save money because of the potential to grow cash value. One of the features of universal life is that you can access your cash value at any time, provided there is sufficient money in the account.

Universal life insurance offers beneficiaries a tax-free death benefit. However, there are some instances where beneficiaries may owe taxes on the cash value of the policy. Here are some key points to consider:

• Modified Endowment Contracts: If the policy is considered a Modified Endowment Contract (MEC), withdrawals and loans may be taxed differently. With an MEC, you must pay taxes on your earnings first, and withdrawals may be subject to an early-withdrawal penalty if you are under a certain age.
• Withdrawal Amounts: Beneficiaries can generally withdraw an amount equal to the total premiums paid without owing taxes. However, if they withdraw more than they have paid into the policy, the excess amount may be taxable as ordinary income.
• Interest Earnings: If beneficiaries choose to refrain from accessing the proceeds of the policy, the insurance company may pay interest on those funds. These interest earnings are typically reported on the beneficiary's annual tax return and may result in taxes due.
• Estate or Inheritance Taxes: Depending on the size of the estate, beneficiaries may owe estate or inheritance taxes on the cash value of the policy.
• Outstanding Loans: If there is an outstanding loan balance when the policy is cancelled or lapses, the borrowed amount may become taxable if it exceeds the cash value of the policy.
• Periodic Payments: Beneficiaries may choose to receive periodic payments from the proceeds of the policy instead of a lump sum. Interest payments on these payments are generally taxable when withdrawn.

It is important to consult with a tax advisor or financial professional to fully understand the tax implications of universal life insurance for beneficiaries.

Frequently asked questions