Whole Life Insurance Interest: Taxable Or Not?

Whole life insurance is a form of permanent life insurance that provides a payout to your loved ones after you pass away. It also has a cash value component that you can use while you're alive. The interest generated from whole life insurance policies is generally not taxed until the policy is cashed out. However, if you choose to receive the payout in installments, any interest accrued may be taxed. While the death benefit is usually not taxable, there are certain situations where it may be taxable, such as when the policy involves three different people or when the payout goes into a taxable estate.

Interest on death benefits

The death benefit is the sum of money that the insurance company pays to beneficiaries when the insured passes away. It is the primary reason for getting life insurance and how policies are almost always described. For example, someone with a $100,000 policy has $100,000 worth of death benefit insurance.

The death benefit is a tax-free payout to your beneficiaries when you pass away. It is the amount payable to your beneficiaries if you pass away while covered by the policy. This amount is typically shown in the benefits schedule of your policy contract.

Interest on whole life insurance policies

Tax Implications of Interest

Whole life insurance policies have a cash value component that grows over time, and this growth is often tax-deferred. This means that you don't pay taxes on the interest earned while the funds remain in the policy. However, if you withdraw more money than you've contributed to the cash value, the excess amount is typically subject to income tax. The same applies if you surrender your policy or borrow against your life insurance and don't repay the loan. It's important to consult with a tax advisor to understand the specific tax implications for your situation.

Interest Rates

Whole life insurance interest rates are usually fixed and guaranteed by the insurer. While this provides stability and predictability, the interest rate may be lower compared to other investment options. The average annual rate of return on the cash value for whole life insurance is typically between 1% and 3.5%.

Impact on Death Benefit

It's important to remember that any outstanding loans, including accrued interest, will generally reduce the death benefit paid out to your beneficiaries. Therefore, if you borrow against the cash value of your policy, ensure you don't borrow too much to avoid reducing the death benefit for your loved ones.

Dividends

If you purchase a whole life insurance policy from a mutual life insurance company, you may receive dividends based on the company's financial performance. These dividends can be used to increase the cash value of your policy, buy additional coverage, or be paid out in cash. This adds flexibility and the potential for higher returns.

Borrowing Against Cash Value

The cash value of your whole life insurance policy can serve as a source of funds through loans. Borrowing against the cash value is a fairly simple process, and the interest rates are often favourable when compared to personal loans or home equity loans. Additionally, these loans are not reported to credit bureaus, so they won't impact your credit score. However, any outstanding loans and interest will reduce the death benefit unless they are repaid.

Taxation on estate

Taxation of Death Benefits

Death benefits from whole life insurance are typically not taxed as income, providing a financial safety net for loved ones. However, if the payout is made in installments, any interest accumulated on those payments will be taxed as regular income. Additionally, if the policyholder leaves the death benefit to their estate instead of directly naming a person as the beneficiary, the value of the estate may increase, potentially triggering estate taxes.

Estate Planning

Estate planning is crucial to minimise tax implications. One common mistake is naming "payable to my estate" as the beneficiary of a life insurance policy. This removes the contractual advantage of naming a person and subjects the proceeds to the probate process, increasing the likelihood of estate taxes. To avoid this, consider transferring ownership of the policy to another person or entity, such as an irrevocable life insurance trust (ILIT).

Three-Year Rule

According to the IRS's three-year rule, gifts of life insurance policies made within three years of death are subject to federal estate tax. Therefore, careful planning is necessary to ensure that ownership transfers occur well in advance of this deadline.

Incidents of Ownership

When transferring ownership, the original owner must relinquish all rights associated with the policy, including changing beneficiaries, borrowing against the policy, surrendering or cancelling it, and selecting beneficiary payment options. Additionally, the original owner should not continue to pay the premiums. Failure to comply with these requirements may negate the tax advantages of the transfer.

Gift Tax Exclusion

Even if a policy transfer meets all the requirements, the transferred assets may still be subject to gift taxes if the policy's current cash value exceeds the annual gift tax exclusion, which is $16,000 for 2022 and $17,000 for 2023.

Tax Strategies

To minimise potential tax liabilities, consider strategies such as choosing a lump-sum payout, avoiding the Goodman Triangle (where the insured, policy owner, and beneficiary are different individuals), using an ILIT, keeping policy loans in check, transferring ownership early, and regularly reviewing and updating beneficiaries.

Tax on gifts

Gifts of money or property to another person are generally considered taxable income. However, there are some exceptions and special rules to consider.

Firstly, it's important to distinguish between taxable gifts and charitable donations. While gifts to individuals are typically subject to the gift tax, donations to qualified charitable organisations are not considered gifts but rather charitable contributions, which may be tax-deductible. It's also worth noting that gifts between spouses are usually unlimited and don't trigger a gift tax return.

The gift tax applies when you receive something of value without giving anything in return or receiving less than its full value. The tax is calculated based on two factors: the annual gift tax limit and the lifetime gift tax limit.

For 2024, the annual gift tax exclusion limit is $18,000 per person. This means you can gift up to $18,000 to a single person without having to report it to the IRS. If you're married, you and your spouse can each give away $18,000, for a total combined limit of $36,000. Exceeding this annual limit doesn't necessarily mean you'll have to pay a gift tax, but you will need to submit IRS Form 709 to disclose the gift. The excess amount will then be subtracted from your lifetime gift tax exclusion.

The lifetime gift tax exclusion for 2024 is $13.61 million per person, or $27.22 million for married couples. This means you can gift up to this amount during your lifetime without paying taxes. Any gifts above this limit will be subject to gift taxes, which range from 18% to 40%.

It's important to be mindful of certain situations that may inadvertently trigger a gift tax return. For example, if you lend money to friends or family without interest, the IRS may consider this a gift. Similarly, if you decide to forgive a loan and not require repayment, that amount is also considered a gift. Additionally, if you set up a joint bank account with someone other than your spouse and they have the right to withdraw money, this could also be treated as a gift.

When it comes to tax on gifts, careful planning and consideration of the applicable limits and exclusions are crucial. Consult a tax professional for personalised advice to ensure you understand the tax implications of any gifts you intend to give.

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.

When to Surrender Your Life Insurance Policy

There are several scenarios in which it may make sense to surrender your life insurance policy. These include:

• You've found a better deal: Although life insurance quotes rise with age, you may be able to qualify for a more affordable policy now compared to 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 instances when you simply may not need life insurance coverage anymore. For example, if no one depends on you financially, it may not make financial sense to keep your policy in force.
• 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 good option, especially if your actual need for life insurance has diminished.

How to Surrender Your Life Insurance Policy

Surrendering your life insurance policy is a straightforward process:

• Gather your policy documents, including the contract, amendments, and payment receipts.
• Notify your life insurance provider that you'd like to surrender your policy.
• The insurer will guide you through their process, which will typically include paperwork such as termination and surrender forms.
• The insurer will review the paperwork and may take anywhere from 7 to 30 business days to process the request.
• Once the surrender request has been approved, the insurer will pay you the cash surrender value through a check or direct deposit.

Pros and Cons of Surrendering Your Life Insurance Policy

Pros:

• Easy and fast: Surrendering your policy is a simple and quick process.
• Get some money back: Surrendering your policy means you'll get some money back, which is better than getting nothing.

Cons:

• Minimal return: Surrendering your policy means you'll only get one offer from the insurance company, and their goal is to give you as little money as possible.
• Surrender fees: Insurance carriers often charge fees for surrendering a policy, which will come out of the cash surrender value you receive. These fees can be up to 35% of the proceeds.
• Limited options: When surrendering a policy, the insurance company will give you a take-it-or-leave-it offer. There is no room to negotiate.

Frequently asked questions