7 August 2013 0 Comments

Taxation Of Life Insurance Cash Values

taxationCash values generated in all forms of permanent life insurance grow tax- deferred. What does tax-deferred mean?  Will there be any tax due if the policy is surrendered, withdrawals of cash are made or cash is accessed through policy loans prior to death of the insured? 

Taxation when policy is surrendered 

If a life insurance policy is surrendered prior to the insured’s death, the cash value received in excess of the total premiums paid (cost basis) is subject to ordinary income tax in the year of surrender.  Capital gains treatment is not available.  The cost basis does not include premiums charged for supplemental benefits such as waiver of premium, accidental death and dismemberment, insurance on spouse and children or long term care benefits.

Taxation of cash withdrawals 

There is no tax due when cash is withdrawn if the total cash value of the policy does not exceed the cost basis.  Even when the cash value does exceed the cost basis, income tax will only be due when the total of all withdrawals from the policy exceed the cost basis.  This is because life insurance taxation is on a first-in-first-out basis, so no tax is due until the entire cost basis has first been received.

An exception to this first-in-first-out rule is when a life insurance policy is a modified endowment contract (MEC).  A MEC is created by paying an excessive amount of premium during the first 7 years of the policy.  When this happens the policy’s living benefits are taxed like an annuity (last-in-first-out), so any gain withdrawn will be taxed first.  Ask your agent if your policy is a MEC and how it is possible to avoid a MEC if you are transferring a large amount of cash from an old life insurance policy to a new one.

Taxation of Policy Loans 

Policy loans are never subject to income tax…well, almost never.  If the policy is a MEC, any loan will be treated just like a withdrawal subject to last-in-first-out tax treatment.  Therefore, if there is a gain in the policy the loan is taxed as income for any amount in excess of the cost basis.  This follows annuity taxation rules.

There is a caution to be noted when policy loans are made.  If the policy lapses or is surrendered with a policy loan against it, the loan need not be repaid, but if the total of the loan, plus any remaining cash in the policy exceed the cost basis, that amount in excess of the cost basis is subject to ordinary income tax in the year of lapse/surrender.  There could be a giant tax bill with no cash left in the policy to cover it.

However, properly managed, the tax advantages of life insurance can provide a great supplement to retirement…and, thats what Ill be covering next.

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