Whole Life Insurance Cash Value: Taxable Or Not?

Whole life insurance is a type of permanent life insurance that includes a death benefit and a cash value component. The cash value of a whole life insurance policy grows tax-free, but there are some instances where you may owe taxes on it. For example, if you take out a loan from your life insurance plan and the policy terminates before you've repaid it, you may have to pay taxes on the loan amount. Similarly, if you withdraw more than the total premiums you've paid into the policy, you may owe taxes on the gains. It's important to understand the specific rules and consult a tax advisor to know the tax implications of your whole life insurance policy.

Withdrawing funds from cash value

Withdrawing funds from the cash value of a whole life insurance policy is a way 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.

The cash value of a whole life insurance policy is generally not taxable as it grows within the policy. However, taxes may apply if withdrawals exceed the total premium payments made. The money withdrawn from cash value is generally made up of two parts: the money that came from premium payments, and the money that came from interest or investment gains. The first part is not taxable, while the second part is subject to income taxes.

It's important to note that withdrawals from a cash value life insurance policy can have consequences. Withdrawing funds may reduce the death benefit, which could be a source of funds for beneficiaries. Withdrawals may also cause the policy to lapse, resulting in a loss of coverage. Additionally, there may be surrender fees involved, especially if the policy is surrendered during the early years of ownership.

To avoid unnecessary taxation, it is recommended to consult with an insurance professional or tax advisor before making any withdrawals. They can help you understand the specific rules and regulations regarding cash value withdrawals.

Surrendering a policy

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.

You'll owe taxes on the amount you receive that's above the cost basis. If your cash surrender value is worth more than you've paid in premiums, you will need to pay income taxes on the difference.

If you surrender the policy during the early years of ownership, when the value is relatively low, the company will likely charge surrender fees, reducing your cash value. These charges vary depending on how long you've had the policy and, often, the amount being surrendered. Some policies can levy surrender charges for many years after the policy is issued.

In addition, when you surrender your policy for cash, the gain on the policy is subject to income tax. Additional taxes could be incurred if you have an outstanding loan balance against the policy.

Although surrendering the policy can get you the cash you need, you're giving up the right to the death-benefit protection afforded by the insurance. If you want to replace the lost death benefit later, getting the same coverage might be more complicated or more expensive.

If you have the means, consider other options before using your life insurance policy for cash, such as borrowing against your 401(k) plan or taking out a home equity loan.

When to Surrender Your Life Insurance Policy

• You found a better deal: Although life insurance quotes rise with age, there's a chance you're able to qualify for a more affordable policy now versus when you first took out your current one. For example, your health may have improved significantly, or you may have quit smoking.
• You can't afford the premiums: Permanent life insurance is significantly more expensive than term life insurance. If the premiums are taking a big bite out of your income, you may be better off with a cheaper term life policy.
• You no longer need life insurance: There are some instances when you simply may not need life insurance coverage anymore. For example, if no one depends on you financially, you may not need life insurance.
• You need a large amount of cash quickly: If you have a major expense to cover or a better investment opportunity but don't have any liquid assets to tap, surrendering a cash-value life insurance policy may be a decent option, especially if your actual need for life insurance has diminished.

Taking a loan from your life insurance

Understanding Cash Value Life Insurance

Cash value life insurance policies, such as whole life or universal life insurance, offer both a death benefit and a savings component. The savings component, known as cash value, allows you to build wealth over time as you pay your premiums. This cash value can be accessed during your lifetime, providing a living benefit. It's important to note that it can take years or even decades to build up a significant cash value.

Borrowing Against Your Life Insurance

To borrow against your life insurance, you need a policy with a cash value component. This feature is typically found in permanent life insurance policies, such as whole life or universal life insurance. Term life insurance, often provided by employers, does not have a cash value. You also need enough cash value in your policy to use as collateral for the loan, and this can take several years to accumulate.

The process of taking out a loan on your life insurance policy is relatively straightforward. You can request a loan from your insurer, either online or through a paper form, without undergoing a credit check or providing income verification. The interest rate on these loans is usually lower than traditional personal loans or credit cards, and the repayment schedule is flexible.

Advantages of Life Insurance Policy Loans

There are several advantages to borrowing against your life insurance:

• No questions asked: You can borrow without explaining the reason, and there is no application process.
• Lower interest rates: Life insurance policy loans typically have lower interest rates compared to bank loans or credit cards.
• Flexible repayment: There is no set timetable for repayment, and you can repay the loan at your own pace.
• No impact on credit score: These loans do not show up on your credit report.
• Interest and dividends: Your policy remains eligible to earn interest and dividends, although at a lower rate than non-borrowed funds.

Disadvantages and Potential Risks

While life insurance policy loans offer quick access to cash, there are some potential disadvantages and risks to consider:

• Reduced death benefit: If you don't repay the loan during your lifetime, your death benefit will be reduced by the loan amount plus any interest owed.
• Risk of losing coverage: If the loan amount plus interest exceeds your policy's cash value, your policy could lapse.
• Tax consequences: If your policy lapses before the loan is fully repaid, you may owe income tax on the amount borrowed above your cost basis (the sum of premiums paid).
• Impact on premium payments: If you borrow against your life insurance, you may no longer be able to use accumulated cash value to pay your insurance premiums.

Key Considerations

Before taking out a loan against your life insurance, it's important to weigh the pros and cons carefully. Here are some key considerations:

• Have a solid repayment plan: Discipline in making regular payments and keeping up with premiums is essential. Consider setting your own repayment schedule and sticking to it.
• Understand the tax implications: Consult a tax advisor to understand the potential tax consequences, especially if you're unable to repay the loan.
• Monitor loan performance: Request an in-force illustration from your insurer to understand how the loan will impact your policy's future performance, and update it regularly.
• Compare alternative options: Explore other options for accessing quick cash, such as personal loans or credit cards, and consider the interest rates and repayment terms.

In conclusion, taking a loan from your life insurance can provide quick access to cash, but it's important to understand the potential risks and tax implications involved. Borrowers should have a solid repayment plan and consult with financial advisors to make informed decisions.

Selling your life insurance policy

There are two types of life insurance sales: viatical settlements and life settlements. A viatical settlement is the sale of a policy by a terminally ill person to an investor. A cancer patient, for example, may need money to cover their expensive medical bills. Life settlements, on the other hand, involve selling a policy to an investor when the seller is usually healthy. A healthy senior might sell their policy to cover rising living costs or to get rid of insurance premiums.

The proceeds from a viatical settlement are not taxable, but life settlement payments are considered taxable income.

• Find an experienced life settlement provider. Researching the life settlement industry is a good way to find a potential buyer.
• Meet the qualifying factors. To sell your policy, you usually need to meet certain criteria, such as owning a policy with a death benefit of $100,000 or more and being over 60 years old.
• Take a detailed health questionnaire.
• Authorize the provider to access your medical records and contact your insurance company.
• Share your policy details with the life settlement provider. Provide a copy of your policy contract and a premium illustration.
• Wait for the underwriting process to be completed. The life settlement company will evaluate your policy and medical records to determine its value.
• Review the offer and decide whether to accept it or opt for an alternative, such as a Retained Death Benefit.
• Complete the closing process, which involves transferring ownership of the policy and the accompanying documentation.

The amount of cash you can get for your policy depends on various factors, including the size of the policy, the life expectancy of the insured, their health, and the expected premium payments.

When considering selling your life insurance policy, keep in mind that there may be tax implications and potential loss of eligibility for financial assistance. Consult a financial advisor or tax expert to understand the full implications.

Interest earned on beneficiary life insurance proceeds

For example, if a beneficiary chooses to receive a $500,000 death benefit in monthly payments of $10,000, and the death benefit earns interest of $100 per month, they will owe taxes on the $1,200 in annual interest earnings.

The same is true for other payout options, such as a retained asset account, where the insurance payout is placed in an interest-bearing account, and the beneficiary can withdraw funds as needed. The interest earned in this scenario would also be taxable.

If the beneficiary receives the payout as a lump sum, they will not have to pay taxes on the interest earned. However, if the money is paid to the insured's estate instead of an individual or entity, it may be taxable.

It is important to note that the tax laws regarding life insurance can be complex and may change over time. Consulting a tax advisor or insurance professional can help individuals understand the specific rules and how they may be impacted.

Frequently asked questions