Taxation of Cash Value on Life Insurance
- Life insurance cash values are generally considered tax free. However, they are not always tax free. When you withdraw money from the policy, it may be taxed. Taxation of cash values depends on the nature and size of the withdrawal. If it is a withdrawal, as opposed to a policy loan, then the cash value is taxable as income to the extent that it exceeds the cost basis in the policy. The cost basis is the amount of all premiums you've paid into the policy.
A withdrawal is when you withdraw money from your policy's cash values. The death benefit and cash value account are permanently reduced when you make a withdrawal. A policy loan is when you borrow against the value of the cash value account, similar to how you would borrow against the value of your home in a home loan arrangement.
- The significance of taxable cash values is that they are taxable as investment income. Investment income is taxed at ordinary income tax rates, which are higher than capital gains tax rates. This means that you pay more in taxes than you would with an investment in stocks, bonds or some other financial product.
- If you cash in your life insurance policy, any gain you realize in the policy is taxed as income. This is irreversible. If your policy lapses due to nonpayment of premiums or from borrowing too much from the policy (called "over-loaning"), all policy loans are treated as forgiven by the IRS. A forgiven policy loan means that the loan is no longer considered to be a loan, and does not need to be paid back to the policy. At this point the forgiven loans are treated as ordinary income subject to taxation.
- By cashing in your policy, you also lose the tax-deferred nature of your life insurance policy by making excessive withdrawals or allowing the policy to lapse. Excessive withdrawals or policy loans are withdrawals or loans from the policy that cause the insurance policy's available cash value to drop to zero. When withdrawals exceed the total premiums paid into the policy, the withdrawals are added to your ordinary income for tax purposes. When you lapse your life insurance policy due to policy loans, you will also increase your gross income, due to the fact that your loans are now considered to be forgiven. Any loan in excess of the total premiums you've paid into the policy are considered part of your gross income after the policy lapses. When you increase your gross income, you also increase your tax liability. Because life insurance is taxed as ordinary income, your overall tax rate may increase on your regular income as well. For example, if you cashed in a life insurance policy and realized a gain in the policy of $40,000, that $40,000 would be added to your annual income in the year you cashed in the policy. This additional income may put you into a higher tax bracket which affects all of your income, not just the income received from the policy.
- To prevent your cash values from becoming taxable, consider avoiding withdrawing, borrowing, or cashing in your life insurance policy if there is a gain in the policy. If you do withdraw or borrow money from your policy, only withdraw money up to your cost basis (the total amount of money you've paid into the policy) and systematically pay back any money you borrow from the policy. Policy loan interest is often charged to the cash values which can cause the policy to eventually lapse.