Life insurance policies accumulate tax-deferred, so their cash value can be borrowed or sold without incurring taxes.
However, when cashing out your life insurance policy via full surrender, partial surrender, loan repayment or direct withdrawal, the IRS could consider some of that money investment income.
Taxes on Investment Gains
Many types of life insurance policies include investment components that allow you to earn money within the policy through interest, dividends or investments. Depending on economic conditions and your financial planning goals, these investments could do well and increase the total amount within it. Should you sell or withdraw from it however, any gains must likely be taxed accordingly.
As your priorities shift, cashing out a life insurance policy may make sense when your priorities change. For instance, if you hold an indexed universal life policy tied to the stock market indexes and now prefer investing in another form of asset over insurance does make sense for your finances.
Whole life policies provide coverage for an initial term – usually 10, 15, or 20 years – before their term has ended, you have several options at your disposal to either renew your old policy or shop around for new coverage. If you decide to keep the old one, either take out all the cash accumulated over time as one lump sum payment, or withdraw small amounts periodically at regular intervals (in which case surrender fees between 10%-20%) may apply and taxes must also be paid on any withdrawals in excess of your policy basis).
Or you could withdraw only part of your accumulated life insurance cash value and allow the rest of the policy to remain active – giving your loved ones still access to death benefits in case you pass away – although this requires paying premiums on top of withdrawing the portion withdrawn, leading to reduced death benefits in return.
If you decide to cash out a portion of your life insurance, withdrawals exceeding its cash surrender value are taxed as ordinary income, including investment gains like dividends received on any remaining portions. An exception would be if selling it for more than you initially paid; then, capital gains tax may apply instead.
Taxes on Loans
Many whole life policies provide their policyholder with access to cash value loans at tax-free interest. If the borrowed amount is paid back before dying, your death benefit could be diminished by its balance plus any accumulated interest, potentially creating a hefty tax bill that’s why it’s essential that any loans or withdrawals be reviewed carefully before taking them out or withdrawing funds from them.
Because whole life insurance policies usually contain high fees and low returns on investments, it’s unlikely they’d ever accumulate more funds than their premium payments can support – if this should occur though, any excess cash would be considered as taxable investment income by the IRS.
Some whole life policies offer accelerated death benefit riders that allow you to access part of your death benefit while you’re still living to cover terminal illnesses or chronic conditions. While this feature can be attractive, the money accessed will usually be taxed as ordinary income and could leave a sizable tax bill behind in its wake if used often or for costly conditions.
Though selling your whole life insurance policy for cash may seem attractive, most people who take this route typically end up paying taxes due to the broker taking a portion of your selling price as their commission and capital gains tax could also apply if more money was exchanged than your cash value amount.
Before selling your life insurance policy for cash, consult a certified financial planner or CPA to assess and plan accordingly. These professionals can help you assess all your options and find an insurance provider with the highest payout for your policy, while they can also establish a life insurance investment account so you can purchase additional policies without incurring taxes – an effective way to diversify your portfolio and potentially boost overall returns.
Taxes on Surrenders
As soon as a policyholder decides to cash out their life insurance policy, they will receive payment from the insurance company. The exact amount depends on how much has accumulated in their policy; typically it should be less than what was spent in premiums; any excess surrender value will be taxed accordingly as distributions. Likewise loans taken out against life policies would also be subject to taxes when cashed in on.
Many whole and universal life insurance policies come equipped with a “cash surrender value” feature, enabling policyholders to withdraw part of their cash value tax-free. This feature may be useful when paying premiums for new policies or covering other costs that don’t fall within existing funds; but before making withdrawals or surrendering policies it is crucially important that any decisions regarding withdrawal or surrendering them take into account any effects it might have on death benefits and future cash flow needs of an estate.
Life insurance policies not only generate cash surrender values but may also accrue dividends and interest that is taxed as ordinary income upon termination or liquidation of their policy, with early withdrawal penalties applying if applicable if this policy falls into the Modified Endowment Contract (MEC) category.
Life insurance policies removed from an estate will likely be subject to gift taxes unless certain criteria are fulfilled, such as ceasing to pay premiums on it and having beneficiaries who aren’t family members of its original owner. To determine the value of such policies considered gifts, divide their total value by the estimated life expectancy of their insured.
Tax implications associated with life insurance are complex and dependent on many variables. To establish whether you owe taxes on an insurance payout, it’s recommended speaking to an experienced tax professional.
Taxes on Direct Withdrawals
Most whole life policies build cash value over time, which can then be withdrawn or loaned without incurring taxes as long as total withdrawal is less than premiums paid until that point. When withdrawing more than your policy’s basis amount however, that extra amount becomes taxable because the IRS assumes it comes from investment gains and taxes accordingly.
If you take out more than your policy’s total cost basis, avoiding tax can be achieved by paying back any excess amounts either in one lump sum or regular installments. To calculate this figure, subtract any outstanding debts or surrender charges from its gross cash value before adding distributions received as contributions to establish its total cost basis.
There are four options for extracting money from a policy: You can withdraw it as a lump sum, divide it among payments over time, surrender the policy or sell it. Each has different implications that must be carefully considered when making any decisions; prior to taking any steps consult with a financial expert first.
When withdrawing your policy’s cash value as a lump sum, any portion that exceeds its basis is considered taxable distribution. This could come from investments or accumulated interest while any excess is simply returned as premiums; such returns do not incur federal income tax liability; however state and local income taxes may apply instead.
Full surrender or cancellation of an insurance policy is considered a taxable event; if your proceeds surpass its surrender value (which includes any outstanding debts), then the IRS will treat any surplus as taxable gain.
Life settlement is another option to sell your policy to an investor; when doing so, he or she pays you an upfront lump sum that falls somewhere between your death benefit and cash value of your policy. At your death, they collect it.