Is the Cash Value of Life Insurance Taxable?

Accountant doing taxes

Cash value life insurance is any type of policy that features a death benefit and a savings element. Common types of cash value life insurance policies include whole lifeuniversalvariable universal, and indexed universal. Cash value policies are permanent, and accumulate value that you can access during your life to pay for emergencies, cover retirement expenses, or even self-cover the policy’s premiums. The savings component of cash value life insurance makes it an attractive option over term policies that do not build cash value.

If you’re considering the purchase of a cash value life insurance policy or already have one, you may have questions about taxes for the cash value. The short answer is that cash value is taxable under certain conditions, but not all. In this post, we’ll discuss situations where there are tax consequences for the cash value of a life insurance policy along with methods to avoid the taxes.

Is the cash value of a life insurance policy taxable?

The cash value of a life insurance policy is generally not taxed while it’s growing within the policy, but taxes may be applicable for any interest or investment earnings that exceed the amount paid through premiums, which is known as the above cost basis amount.

The death benefit of a cash value policy is generally not subject to tax. Beneficiaries can choose to accept the full amount in a lump-sum payment that’s tax-free. However, taxes may be applicable on the death benefit if beneficiaries choose to receive it in installments or an annuity. These options place the death benefit into an interest-earning account and distribute regular payments over time. Taxes will have to be paid on any interest earned from the account. For example, consider a scenario where a beneficiary receives a $120,000 death benefit and chooses to receive monthly payments of $2,000 over the next five years. The death benefit remaining in the account will earn $50 in interest each month, and the beneficiary would need to pay taxes on the $600 annual proceeds ($50 per month x 12 months = $600).

When is the cash value of life insurance taxable?

There are a few situations in which you may be taxed on the cash value of a life insurance policy:

1. Ending a policy with a loan on the cash value

Permanent life insurance policies allow you to take a loan on the cash value of the policy. You won’t have to pay taxes as long as the policy is maintained, but you may have to pay taxes if your policy ends before you’ve repaid the loan. This includes situations where you cancel the policy, let it lapse, or surrender it. So you can avoid taxes by keeping the policy in force, but ending coverage may result in a tax penalty.

On the bright side, you won’t have to pay taxes on the full loan amount. You only need to pay taxes on the amount above the policy’s basis, which is the interest earned. The money you’ve paid towards premiums will not be taxed, even if your policy ends with a loan balance that hasn’t been paid off. For example, say you borrow $10,000 against the cash value of your life insurance. Assume $9,000 of this amount comes from premiums you’ve paid, and the remaining $1,000 is from interest that’s accumulated over time. You won’t be taxed as long as you keep the policy in force, but if you need to cancel it for any reason, you’ll only be taxed on the $1,000 in interest you borrowed.

2. Withdrawal of cash value funds

If you’re in a tight situation and you need to access the cash value of your policy, you can withdraw money from it. However, withdrawals before the age of 59.5 may be subject to a 10% tax penalty. You’ll also be taxed on any proceeds that exceed the amount you’ve paid towards premiums, regardless of your age.So if you’re 65 years old, you won’t have to pay an early withdrawal tax but you will have to pay taxes on money above your cost basis. Say you have a policy that you’ve paid $15,000 in premiums towards, but has a cash value of $20,000 — it means the policy generated $5,000 from interest or investment returns. You can withdraw the $15,000 you paid without any tax consequences, but you’ll have to pay tax on the $5,000 that was earned.

3. Surrender of the policy’s cash value

If the policy becomes unaffordable or you no longer wish to maintain coverage, you can surrender it to the insurance company for the cash surrender value. The cash surrender value is the total cash value you’ve accumulated, minus any loans and surrender fees that will be charged by the provider. Surrender fees vary by insurer, but typically go down the longer you own the policy. Like taking a loan on the policy or withdrawing funds, you’ll need to pay taxes for any cash value you receive above the cost basis. So if you surrender a policy for $20,000 and $5,000 of that is from interest gained, you’ll only need to pay taxes on the $5,000 and not the $15,000 paid through premiums.

4. Sale of the life insurance policy

You may be able to sell your life insurance policy, which awards five times the cash surrender value on average according to LISA. You can sell your life insurance policy directly to a provider, or work with a broker who will present it to multiple parties to create a bidding environment that drives up the price. When you sell your policy, the buyer will provide a lump-sum payout that you can use however you want. The buyer also takes on responsibility for maintaining premiums, and collects the death benefit when you die.
It’s also important to note that there are two different transactions in which a life insurance policy can be sold.

  • Life Settlement: The sale of a life insurance policy to a third-party buyer. The main eligibility requirements are the person’s age, policy value, policy type, and health status.
  • Viatical Settlement: Similar to a life settlement, but is only available for people with a chronic or terminal illness and typically has a higher payout.

While life and viatical settlements both refer to the process of selling a life insurance policy, they have different tax consequences. Proceeds from a life settlement are considered taxable income, so the seller will likely have to pay taxes during the transaction. Meanwhile, proceeds from a viatical settlement are considered a type of death benefit and not subject to tax.

5. Conversion of a Cash Value Policy to an MEC

Due to the tax benefits of a cash value policy, you may be tempted to put as much money as possible into the policy. However, overfunding it will lead to it being converted to a Modified Endowment Contract (MEC), which comes with some tax consequences. Unlike a cash value policy that lets you take money out of the premiums you’ve paid to avoid taxes, an MEC requires you to withdraw money on an income-first basis. Since you’re taking out income generated from the policy, you’ll be subject to taxes on withdrawals.

How to avoid taxes on a policy’s cash value

There are three basic strategies to avoid tax consequences related to a life insurance policy’s cash value:

  1.  Stay Below the Cost Basis: In general, you won’t have to pay taxes on the cash value of a policy unless that cash value exceeds the premiums paid, which is your cost basis. Your cash value will grow over time from interest and investment gains, but you can avoid taxes by only taking out what you’ve paid in.
  2. Maintain a Policy with a Loan: You won’t be taxed on a loan taken from your policy’s cash value, even if it’s above the cost basis. So you can avoid taxes by taking a loan for the cash value and maintaining coverage.
  3. Avoid Overfunding: Overfunding your cash value policy will lead to it being reclassified as an MEC by the IRS, which requires you to make withdrawals on an income-first basis. This means you’ll have to take out money gained from interest and investments before you can withdraw money paid through premiums, and as a result, you’ll have to pay taxes. To prevent this, talk with your insurance provider to ensure you don’t overfund through premiums.
  4. Delay Withdrawals: Withdrawing cash value before the age of 59.5 will result in a 10% tax penalty, so avoid taking out money until you’ve surpassed this age.

Avoiding taxes on a cash value policy can be tricky, and if none of these strategies are suitable for your situation — your best choice is maximizing your return. Selling your life insurance policy may allow you to achieve this, as you can get up to 60% of the death benefit amount in a lump-sum payment and an average value that’s five times higher than the cash surrender value. While you may take a tax hit during the transaction, a higher return can make it worthwhile. Additionally, you may be able to reinvest the proceeds into another source that has more favorable tax treatment. To get a free estimate on the value of your life insurance policy, contact us or use our life settlement calculator for an instant evaluation.

Lucas Siegel

Lucas Siegel

Lucas Siegel is the founder and CEO of Harbor Life Settlements, a life settlement company that is dedicated to helping seniors and the terminally ill sell their life insurance policies, and Harbor Life Brokerage, a life settlement broker that helps policyholders receive the maximum cash value for their policy. He is an expert in the the life and viatical settlement industry, and has been featured in reputable publications such as ThinkAdvisor, WealthManagement, and Investment News.

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