Tax Consequences of Cashing in Life Insurance Policy [2021]

Tax Consequences of Cashing in Life Insurance Policy in 2021

Tax consequences of cashing in life insurance policy

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Nobody buys a permanent life insurance policy to trade it for cash at a later time. Sometimes some situations that need immediate access to funds arise, and you are left with no option but to dip into your life insurance cash value. Can you relate? Well, there’s good news! There are several options available for you, and you don’t necessarily have to lose your policy. 

However, they come with tax consequences, so before you decide, you need a thorough knowledge of the tax consequences of cashing in life insurance policy. Don’t worry! We’ve broken it down in this article.

Want to know the tax consequences of cashing in life insurance policy? In this article, you’ll learn what the cash value of life insurance, the tax consequences of cashing in life insurance policy after a withdrawal, the tax consequences of cashing in life insurance policy after surrendering your policy, and what happens when you sell your insurance policy. Read on!

What is the Cash Value of Life Insurance?

There are no tax consequences of cashing in life insurance policy without meeting the cash value. The cash value is the reason universal life insurance policies cost more than term life insurance policies. You pay extra premiums monthly, and the insurance company invests the additional premium while you get a part of the returns. 

The cash value accumulates over time. Someone who pays premiums regularly and has been doing it for a couple of decades would have a more substantial cash value available than someone who has only made premium payments for a few years. 

Pros and Cons of Cashing in Your Life Insurance Policy

Pros:

  • You can withdraw funds at any time. All you need to do is fill out a form, and you’ll get the desired amount right away as long as it’s within your limit. This chance is mainly available for universal life policies. There’s no cash value in whole life policies’ starting years. 
  • You are free to use the funds however you deem fit. You are not required to prove or justify how you spend the money withdrawn.
  • You can use the money to sort out emergencies, help loved ones, or for pleasure.

However, there are downsides.

Cons:

  • You need the agreement of an irrevocable beneficiary else; you won’t be able to access the money.
  • Withdrawals are final, and the following payments will not count as refunds.
  • The portion of the money that generates investment returns will be taxed. The tax consequences of cashing in life insurance policy come in here.
  • The death benefit amount will be reduced. 
  • In some cases, you might have to cancel the policy. Some contracts do not allow partial withdrawal. 
  • Withdrawing from your policy will hinder the growth of your policy’s current and future cash value.

Options for Cashing in Life Insurance

There are four available options for cashing in on most whole life insurance policies. You can choose to borrow using the cash value as collateral, surrender your policy for the cash value, withdraw a part of the cash, or sell out your policy for cash. Before we discuss the tax consequences of cashing in life insurance policy, let us have a look at these options one after the other.

1. Withdrawing from the Cash Value

You can withdraw a limited amount of cash from your life insurance policy. The total amount available depends on your type of policy and the insurance company. The most significant advantage of withdrawing from your cash value is that as long as your policy is a non-MEC (modified endowment contract), your cash-value withdrawals will be tax free. A MEC is a life insurance policy whose funding is above federal tax law limits.

However, there are some consequences associated with cash-value withdrawals:

  • If your cash value withdrawal reduces your cash value, it could lessen your death benefit and deprive your beneficiaries of the money they could be counting on.
  • Withdrawals are not always tax-free. The tax consequences of cashing in life insurance policy apply sometimes. For example, if you took a withdrawal during the first 15 years of your policy and the withdrawal led to your death benefit getting reduced. There is a possibility that some or all of the withdrawn cash would be subject to taxation. 

Sometimes, withdrawals are treated as taxable to the point that they go above your basis in the policy.

  • If your withdrawals reduced your cash surrender value, to maintain the same death benefit, your premiums might increase; else, the policy could lapse.
  • If your life insurance policy has been classified as a MEC, your withdrawals will be taxed the same way as annuities. Your initial withdrawals would be considered taxable interest until you have withdrawn enough money to dip into your principal. 

If you’re under age 59 ½, you’ll have to pay a 10% early-withdrawal penalty. Altogether, as long as you withdraw less than the total amount of your premium payments, your withdrawals would be tax free.

2. Surrendering Your Life Insurance Policy

You might decide to surrender your policy for many reasons. Maybe you found out you qualify for a cheaper term life insurance policy, or perhaps you feel you don’t need life insurance coverage anymore. Whatever the reason, you can surrender your policy by simply calling your insurance. Unlike term life insurance policy, where all you have to do is stop paying the premiums, in this case, you have to call your insurance company.

If you surrender your policy during the early years, you’ll be charged surrender fees. The surrender fees will reduce your cash value. The total amount you’ll be charged depends on how long you’ve been on the policy.

When you surrender your policy for cash, the gain on the policy is liable to income tax. If you have a pending loan balance against the cash value, you might be subject to additional taxes.

Another thing to consider before surrendering your policy is you’ll be giving up your death benefit.  It may be more difficult or expensive for you to get replacement coverage in the future due to age or a decline in health. To get death benefit at an affordable cost, you might be left with a term policy as the only option instead of an option with cash value. 

3. Selling Your Life Insurance Policy

As the policy owner, you can sell your life insurance policy to an individual or a life insurance settlement company in exchange for cash. The new owner will keep the policy and continue to pay premiums. He’ll in turn, receive the death benefit when you die.

Most insurance types are eligible for sale, including policies like term life insurance that have no cash value. However, there is an age restriction. Before you can sell your policy, you have to be at least 65 years old, have a life expectancy in the 10 to 15 years range, and in most cases, your death benefit should be at least $100,000.

The taxes on life insurance settlements is complicated. The general rule: any gain above your cost basis in the policy will be taxed as ordinary income. 

Before you sell your life insurance policy, ensure you get expert advice. Remember that you’ll be giving up your death benefit, and the new policy owner will have access to your past medical records and reserves the right to ask for updates on your current health status.

Also, it’ll be difficult for you to know if you are being given a fair price for your policy so it’ll be left to how well you can negotiate. You’ll also have to pay about 30% of your proceeds in fees and commissions, reducing the total amount you’ll get.

4. Borrowing on the Life Insurance Policy

One way to access your policy’s cash value is to borrow or take a loan against the cash value. This means your cash value will be used as the collateral. However, depending on your policy’s terms, the insurance company will likely charge interest at different rates on the loan amount, which you have to pay either from the cash value left or in cash.

One of the pros of this policy is there are no written or financial requirements for people who wish to take a loan from their policies. So you don’t have to qualify for the loan financially. 

Another advantage is that you may not have to pay back the loan. The insurance company will simply reduce the total amount of your death benefit by the unpaid balance of the loan.

However, it is advisable to repay the loan if you plan to keep the policy. That’s because you’ll be charged interest on the loan, and the unpaid loan will reduce your death benefit, making your beneficiary receive less money than you planned. 

Also, your cash value will keep reducing as the outstanding loan continues to accumulate interest. This can cause the policy to lapse if you don’t pay enough premiums to keep the death benefit. If the loan is still unpaid by the time the policy lapses or you surrender the insurance, the borrowed amount becomes taxable, and the cash value can go above your basis in the contract.

How Much of a Life Insurance Policy Loan Is Taxable?

As long as the money you loan is equal to or less than the total amount of insurance premiums you’ve paid by the time the policy ends, it is not taxable. 

A taxable income is an amount received from the cash value minus the net premium cost. It can also be obtained by subtracting the distributions received from the total premiums paid. 

Let’s paint a scenario. You have a life insurance policy with a cash value of $500,000. You paid $200,000 in premiums but have an unpaid $400,000 policy loan with no distributions. If your policy lapses at that time, the income on your taxes is $300,000.

This could be problematic if your interest payments were made through dividends or the policy’s cash value and not out-of-pocket. Interest payments made out-of-pocket are not tax deductible and those not made out of pocket do not cover the total amount of interest due. Your compound interest will be added to the principal. 

If your loan remains unpaid and accumulates interest for decades with little interest payments made when a taxable event occurs, you may find yourself owing taxes on a balance that is far greater than what you initially borrowed.

Tax Consequences of Surrendering Your Life Insurance Policy

If your policy has no cash surrender value(CSV) or if the policy’s ACB (adjusted cost base) is greater than the CSV, then you’ll not experience any of the tax consequences of cashing in life insurance policy. If the policy’s CSV is greater than the ACB, the insurance company will issue a T5 to the policyholder for the difference.

Tax Consequences of Withdrawing from Your Life Insurance Policy

If you withdraw part of your policy, there will also be no tax consequences of cashing in life insurance policy if the ACB exceeds the CSV. However, if the policy’s CSV is greater than the ACB, then a special rule would determine how much of the policy’s ACB would be allocated to the cash withdrawal.

For example, if the policy’s CSV is $15,000, the ACB is $8,000, and you withdraw $5,000. The ACB allocated to the withdrawal would be $5,000 × $8,000 ÷ $15,000, which gives $2666. The taxable gain is $2334 ($5,000 − $2,666). The policy’s Adjusted Cost Base drops to $5,666.

Tax Consequences of Borrowing from Your Life insurance Policy

Borrowing or obtaining a policy loan means getting an amount from your insurance company in advance. The advance is given under the policy terms from the cash surrender value. As explained earlier, it’s not a must you repay the loan, so it’s not a loan in commercial terms.

A loan in cash by the policyholder would decrease the policy’s ACB. Borrowing only leads to tax implications when it exceeds the policy’s full ACB.

Determining Your Total Tax Commitments

The money received from the cash surrender value is taxable as ordinary income and not capital gains. This implies that this money will be subjected to the federal income tax regulations and any state-level income tax policies.

When reporting this income on your tax return, you will use the standard IRS Form 1040 and name your policy’s profit as “other income.” Don’t forget to report this profit on Form 1040 as tax filing else, you can attract several penalties and fines from the IRS.

After committing to your cash out, your life insurance provider will give you a 1099-R that lists the gross payout from your policy after the cash-out. You can use this information as an official point of reference when filing your tax documents.

Some Frequently Asked Questions –Tax Consequences of Cashing in Life Insurance Policy

Can you cash out term life insurance?

No, term life insurance has no cash value. It only pays a death benefit to your beneficiary or spouse if you die within the policy’s term. Authentic guide to buying term life insurance gives well-detailed information on this policy.

When cashing in a life insurance policy, do you pay taxes?

If you have a cash value life insurance policy, you can get the money through a withdrawal, taking a loan against the cash value, or by surrendering the policy and ending it. This brings us to the tax consequences of cashing in life insurance policy. The money within the cash value account is tax-free, depending on the interest or gains it earns.

What happens when you surrender life insurance policy?

When you surrender a life insurance policy, the policy owner will receive all of the policy’s remaining cash value. This cash value is known as the cash surrender value. The CSV will be a little less than the policy’s total amount of cash value because of surrender charges assessed by the policy.

What are the tax consequences of the interest growth on the cash value in a whole life policy?

The tax consequences of cashing in life insurance policy does not apply while the cash value of your whole life insurance policy is still accumulating. In this case, it will not be taxed. It is known as “tax-deferred.”

It means your money grows at a faster rate because it’s not being reduced by tax deductions yearly and the interest on your cash value is applied to a more significant amount.

What happens to a life insurance policy when policy loan balance exceeds cash value?

When you borrow the money against your cash value, the amount you borrow may cause the death benefit from your life insurance policy to drop. If you do not repay the loan, and the interest together with the amount borrowed exceeds the cash value, you are putting your life insurance policy in danger.

What happens when cash value exceeds death benefit?

When the policyholder dies, the beneficiaries get the death benefit, and the remaining cash value goes back to the insurance company. They’re practically discarding the accumulated cash value. 

Awesome! You made it to the end and now you know the tax consequences of cashing in life insurance policy! Economic issues can lead you to consider cashing in your policy. Perhaps you are in a very tight spot and have no other option. Whatever the reason might be, the critical step you should never forget is to seek the advice of a qualified life insurance professional before making your decision. We have more exciting insurance content. Subscribe to our newsletter below to get them firsthand.

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