Is Life Insurance Cash Surrender Value Taxable
Confusion abounds around the taxability of cash surrender values from life insurance. The tax-free characteristic of life insurance is frequently praised by agents. However, the marketing materials frequently include a ton of footnotes on the topic of taxes.
So, is your life insurance cash surrender value taxable? Yes, it is the solution. The reply is similarly negative. The correct question isn’t, in fact, “Is my life insurance cash surrender value taxable?” When is the cash surrender value of life insurance taxable is the correct query.
General Principle: The Life Insurance Contract’s Cash Value
Generally speaking, monetary value that is still included within a life insurance policy is not taxed. This implies that when the cash worth inside a life insurance policy increases, you won’t have to pay taxes on the interest or dividends that are paid on it. The primary characteristic is that everything stays inside the policy.
Cash Value Accumulation Deferred Taxes
Wendy owns a universal life insurance policy that earns $4,000 in interest this policy year. Because the interest earnings remain inside the life insurance policy, Wendy will not owe taxes on the $4,000 interest earnings on her cash surrender value.
Notice that in the example above life insurance taxability is different from an ordinary savings account. If Wendy earns $4,000 on her savings account this year, she will need to report the interest earnings as income when she files her taxes. She will then owe ordinary income taxes on the $4,000 interest payment. Because the interest earnings remain inside the life insurance policy, Wendy does not owe taxes on it. Wendy can compound her cash surrender value growth through the interest payments and she will owe no taxes on the interest payments so long as the cash value remains in the policy.
Example of a Whole Life Insurance Dividend
Harold has a whole life insurance policy, and this policy year it paid dividends totaling $4,000. Harold decided to use the dividend income to buy paid-up additions. Harold doesn’t have to pay taxes on the dividend payment if he uses the paid-up additions option with the dividend payment to retain the money within the policy.
When a Life Insurance Policy Loses Money
There are two ways to withdraw funds from an active life insurance policy. First, a partial surrender can be used to withdraw money. Another option is for the policyholder to borrow money against the life insurance coverage. Let’s investigate if these behaviors are taxable.
Withdrawing Money from a Life Insurance Policy
Life insurance enjoys many tax-favorable treatments. One beneficial tax treatment of life insurance is the First In First Out (FIFO) accounting principle. FIFO allows the policyholder to recoup his/her contributions to the policy before he/she must remove gains from the policy.
Example of a FIFO Life Insurance Withdrawal
Emanuel is the owner of a full life insurance policy with a cash value of $500,000. He has so far paid a total of $150,000 in premiums. He wants to take $50,000 out of the insurance.
Emanuel is eliminating a portion of his payments to the coverage (the $150,000 he paid in premiums), thus the $50,000 is not taxable to him. The FIFO rule allows holders of life insurance plans to withdraw money from their policies up to the amount they invested without incurring tax liability. This is so because they are formally withdrawing the money they invested in the policy.
The alternative to FIFO is Last in First Out (LIFO). Under this accounting rule, the account holder must first remove any gain before he/she can remove contributions (also known as cost basis). Using the example above, if Emanuel withdrew the money from an account that uses LIFO, he would owe taxes on the $50,000 distribution because the account currently has a $350,000 gain. Luckily, all life insurance policies use FIFO accounting rules.
Withdrawing Money Beyond the Basis
Emanuel decides instead that he need to withdraw $200,000 from the policy. Doing this, Emanuel will owe taxes on $50,000. He owes no taxes on $150,000 of the withdrawal because that is his cost basis in the policy. The $50,000 remaining is part of the gain he achieved with the policy and he’ll owe ordinary income taxes on this sum. Any amount withdrawn above the cost basis of a life insurance policy is taxable as ordinary income. If Emanuel canceled the entire policy, he’d receive $500,000 in cash from the life insurance company. He would also owe taxes on $350,000.
Using Life Insurance Policy Loans to Avoid Taxes
As I already mentioned, you can also use a life insurance policy loan to take money out of a policy. Actually, a loan doesn’t remove money from your policy. What technically happens is a pledging of the money in the policy as collateral for a loan issued by the life insurance company to the policyholder. The cash in the life insurance policy never leaves the policy.
Because the money never leaves the policy and because the IRS does not view loans as income (in most cases) the life insurance policy loan is a non-taxable event. This is true even when generating a loan that goes beyond the cost basis of the policy.
Loan and Withdrawal Distribution
Instead of withdrawing all $200,000 from his policy, Emanuel’s agent suggests he take a $150,000 withdrawal and a $50,000 loan to avoid tax liability.
Taking the distribution from the policy in this fashion completely avoids any taxability to Emanuel. He withdraws his basis, which is nontaxable to him. He then takes a loan for the remaining $50,000, which also has no taxability to him.
Life insurance policyholders can use loans on cash surrender value to avoid taxes without needing to withdraw any money. From the example above, Emanuel could simply take a loan for $200,000 and he’d have no tax liability. The decision to take a withdrawal versus a loan can be complex and we’ll address it in more detail in another blog post. I simply want to point out that one doesn’t necessarily have to withdraw money up to his/her basis first before taking a policy loan.
To avoid taxes, a life insurance policy MUST remain in force.
You must be aware that, if you use a loan, the loan’s tax-free status will only last as long as the life insurance policy is in place. You will be required to pay taxes on any gain from a life insurance policy cancellation if there is an outstanding debt on the policy.
Canceled Policy with Outstanding Loan
Emanuel has a whole life policy with $500,000 of gross cash value. He paid a total of $150,000 in premiums to the policy. He also has a $200,000 outstanding policy loan. He decides to cancel his life insurance policy.
Emanuel receives $300,000 in cash from the life insurance company. This is his cash surrender value after repaying the loan. He will owe taxes on $350,000 because of the $50,000 he already distributed from the policy through a policy loan.
It is possible, though not very common, to cancel or lapse a life insurance policy with significant outstanding policy loans. In this situation, the taxes due may far exceed any remaining cash value received upon policy termination. For this reason, policyholders should take some cautions to ensure canceling a policy will not cause substantial tax liability due to outstanding loans on the policy. It’s also important to know that if the policyholder dies, the taxability of the distributions through policy loans goes away. Because the policy ended up paying a death benefit, there is no tax liability on the outstanding policy loans. The insurance company will use a portion of the non-taxable death benefit to pay the outstanding policy loans and the remaining death benefit will go to the beneficiaries.
Example of Death with Outstanding Loans
Emanuel has a complete life insurance policy with a $500k gross cash value. He paid the policy’s premiums totaling $150,000. He has loans totaling $200,000 that are still unpaid. The policy provides a death benefit of $1 million. Death occurs to Emanuel.
He will repay the insurance company a share of the $1 million death benefit, or $200,000, for the outstanding debt. His beneficiary will get the remaining $800,000 in death benefits. Despite the ongoing loan that dispersed $50,000 of Emanuel’s policy’s profits, neither he nor his beneficiaries owe any taxes.
Cash Surrender Value And The 1035 Exchange
There are times when people wish to buy new life insurance. There are also times when people wish to buy new life insurance and transfer the cash surrender value of their old policy into this new policy. Thankfully, tax law does allow for a very tax-efficient mechanism to accomplish this.
The 1035 exchange allows a life insurance policyholder to transfer the cash surrender value of his/her policy into a new life insurance or annuity policy without owing any taxes on the gain of the policy.
If the 1035 exchange didn’t exist in U.S. Tax Code, then anyone wishing to buy a new policy and moving cash in his/her old policy to the new policy would need to:
- Surrender the old policy
- Use the cash received by policy surrender to pay premiums on the new policy
- Report the gain from the cash received by the old policy surrender as income
- Pay taxes on the gain from the old policy
Luckily none of this is necessary, as policyholders can simply move the money from an old policy to a new one through the 1035 exchange. Policyholders can also transfer their cost basis from the old policy to the new policy. This might have strategic tax benefits.
But you shouldn’t assume that just because you have cash surrender value in your old policy, you have to use a 1035 exchange when buying a new policy.
If the old policy has no gain, then the 1035 exchange’s tax-free transfer feature is moot. You wouldn’t owe taxes when canceling your old policy because you’ve paid more in premiums than you have in cash surrender value.
The information above specifically relates to life insurance.
I wish to emphasize that the aforementioned instances exclusively refer to life insurance. You have a contract with drastically different provisions regarding the taxability of cash surrender value if your policy violates the Modified Endowment Contract Test.