Is Cash Value Life Insurance Taxable?

Is Cash Value Life Insurance Taxable? Depending on the policy, money in the cash value account grows tax-free based on interest or investment gains. However, if you take the money out, you might have to pay taxes.

The cash value of a life insurance policy can be accessed through a withdrawal, a loan, or surrendering and terminating the policy.

The ability to access the money that accumulates within the policy is one of the reasons to purchase cash value life insurance. There are three places where premiums are paid: Cash value, the price of insurance, and fees and charges for the policy.

Is Cash Value Life Insurance Taxable?

Depending on the policy, money in the cash value account grows tax-free based on interest or investment gains. However, if you take the money out, you might have to pay taxes.

In most cases, the money that is taken out of the cash value consists of two parts:

Money derived from your premium payments: This portion of a withdrawal is not subject to taxation. This section is referred to as the “policy basis” in the life insurance industry.

Money derived from investment gains or interest: This portion is subject to income tax if withdrawn. You can find out how much of a withdrawal is considered “above basis” and subject to taxation from your life insurance company.

If your insurance is a “modified endowment contract,” or MEC, different duty rules apply and it’s ideal to counsel a monetary expert to figure out different charges.

 

What kinds of money are subject to taxation?

In the following scenarios, cash value may be subject to taxation.

You give up your life insurance policy: In some cases, a policyholder may decide that they no longer require or want their life insurance policy. The life insurance company will end your coverage if you take the policy’s surrender value. Your cash value less any surrender charges is what you get. Within the first 10 to 20 years of owning the policy, you can anticipate receiving a surrender charge which gradually decreases over time.

However, you will not be taxed on the surrender value in its entirety. The total premium payment you made on the policy, less the policy basis, will be subject to taxation. The investment gains you took out are reflected in this taxable amount.

You took out a loan against the policy, and your life insurance has ended: If you have cash-value life insurance, taking out a loan against it is not taxed as long as the policy is in effect. However, if the policy expires before you have repaid the loan, you may be subject to a tax bill. For instance, if you surrender the policy or it expires, the coverage ends.

The loan amount that exceeds your policy basis determines the taxable amount. The amount you have paid in premiums is your policy’s basis. Sums “above premise” depend on revenue or venture acquires on cash esteem.

Withdrawing the amount that is your policy basis—which is not taxable—is one way to access all of your cash value and avoid paying taxes. The remaining cash value can then be accessed with a loan, which is also tax-free.

READ: Is Cash Value Life Insurance A Good Investment?

The death benefit is reduced by the amount of the outstanding loan if the policyholder dies with a loan against the policy.

If the insurer decides to cancel the policy, it will use the policy’s cash value to pay back the loan, and you will be required to pay tax on any amount that is greater than the basis of the policy. Keep in mind that if you die before repaying the loan, any remaining debt is deducted from your death benefit, resulting in less money for your beneficiaries.

 

You sell the life insurance policy: There is a market for existing policies, particularly cash value policies that protect people who are terminally ill or have a short life expectancy. This involves paying you money for the policy, becoming the policyowner, and then making a claim on your life insurance in the event of your death from an investor (such as a company that specializes in buying policies).

While selling a life insurance policy will result in receiving more money than simply surrendering it for the cash value, abusive settlements are utilized by patients as a means of obtaining financial assistance for medical expenses.

On the sale of a life insurance policy, the IRS imposes two kinds of taxes based on your profits:

  1. The cash value that is greater than the basis of the policy is subject to income tax.
  2. Any other profits from the sale, such as money you receive that is greater than the policy’s cash value, are subject to capital gains tax.

If you want to get out of a life insurance policy and buy a new one, you might be better off trading it as part of a 1035 exchange, which lets you trade similar properties without paying capital gains tax.

 

Types of Life Insurance Taxes You Should Be Aware Of

Prior to discussing the tax events that can have an effect on a life insurance payout, let’s examine the various types of taxes that may be involved.

  • Revenue Taxes: This kind of tax is something you have to deal with every year. It is merely the income tax imposed by the federal government or, in some jurisdictions, the state. The Internal Revenue Service (IRS) calculates your yearly tax liability based on your net income tax bracket and allows you to deduct certain expenses.

 

  • Estate Duty: Basically, when someone dies, the federal government and some states add up the value of all their assets (property, investments, life insurance, and annuities), subtract the value of all their debt (loans, medical bills, credit cards), and tax the result. The beneficiaries of an estate are not responsible for paying an estate tax. However, there is good news. The majority of estates are exempt from this federal tax because, as of 2023, only estates valued over $12.92 million are required to pay it. Additionally, even states that have an estate tax do not tax estates valued between $1 million and $7.1 million.

 

  • Inheritance Tax: The fact that so few people will be affected is the only thing to celebrate here. An inheritance tax is distinct because it is a state tax paid by the heir on inheritances. Fortunately, only six states levy this type of tax: Pennsylvania, Iowa, Kentucky, Maryland, Nebraska, New Jersey. The six states on the list are the only ones where the inheritance tax applies, and even then, it only applies to certain types of heirs. You probably won’t be affected by it because it’s so uncommon, but if you live in one of those six areas, find out what kinds of heirs might be subject to an inheritance tax.

 

  • Age Skipping Duty: On this one, the name pretty much says it all. It is, in essence, a tax on an inheritance when the heir is not the next immediate descendant or a “skip person,” regardless of whether that person is in the family. This tax can also apply to money a skip person inherits through a trust. For instance, a grandfather could “skip” his own child and leave an inheritance to his granddaughter.

In addition to the standard death benefit found in many life insurance policies, cash value life insurance offers potential flexibility and tax benefits that you may not have considered. For instance, the cash portion of the policy allows gains to accumulate and grow tax-deferred over the policy’s lifetime. Additionally, as long as you do not borrow more money than the policy’s basis, you are exempt from paying income tax on any loans secured by the policy. Talk to your financial advisor if you want to learn more about how a cash value life insurance policy might fit into your long-term plans.

Things to think about:

  • Cash value life insurance gives your financial plan more flexibility.
  • Secure additional tax deferral with cash value life insurance.
  • Borrow up to the cash value of a cash value life insurance policy income-tax-free.

 

Is group term life insurance taxable?

Group life insurance policies which some businesses provide as an employee benefit, have specifics. On the off chance that you have a strategy worth under $50,000, the expenses aren’t available. However, the premiums will be subject to income tax if your coverage exceeds $50,000 and your employer subsidizes all or part of the cost. This is on the grounds that the IRS considers the life coverage expenses your supervisor pays to be essential for your remuneration.

READ: Cash Value Life Insurance Australia

Taxation only applies to the portion of the premium that goes beyond $50,000 to cover the coverage. In order to account for the tax, some employers raise the employee’s income.

There is no income tax to pay if you buy life insurance through your employer and pay the premiums yourself.

Discover more from LoveyBlog - Lovey Insurance Blog

Subscribe now to keep reading and get access to the full archive.

Continue reading

Scroll to Top