I bought a whole life cash surrender value policy a number of years ago. When I die will my beneficiaries have to pay tax on the cash value? If so, would I be better off cashing in this policy and making another type of investment?

Richard Crew, Beeville, Texas

Good question, Richard. The proceeds from the death of the insured are tax-exempt, which is why whole life insurance is so popular in order to transfer wealth tax-free. Keep in mind that if you cash in a policy early, you may have taxable income.

Think of life insurance as a savings account. You pay premiums into a policy and the insurer uses a portion of your payments to cover the life insurance protection; the rest is invested. After a number of years making premium payments, you are credited with what is called a cash surrender value, or CSV. If should decide to cancel the policy, and the CSV is more than the premiums, the excess is earnings and taxable income. Let’s say your annual premiums are $1,000 and you have had the policy for 20 years, your premiums are $20,000. Then you cash in your policy and receive $30,000, you’ll subtract the $20,000. and pay ordinary income tax on the difference which is $10,000 in earnings.

The life insurance company will issue you a Form 1099-R showing the total proceeds and the taxable part. You will submit this form and be taxed in the year that you cashed in the policy.

Clarify with your CPA

Before you make a decision of whether or not you should cash in your cash surrender value policy, you should talk to your Insurance Agent or CPA for clarity and compliance with requirements imposed by the IRS. A little caution can avoid penalties under the Internal Revenue Code.

Reader Question

I need to borrow against my Life Insurance but I was told I would have to pay tax on any withdrawals. If this is true at what tax rate would I be assessed?

Sincerely, Alfred in Oklahoma

Thank you Alfred for your question. If you have a variable and traditional whole life policies, you may not be allowed to withdraw from your cash value. Examine you policy to assure any withdrawal you make will be tax free up to the amount of premiums you have paid into the policy, minus any prior dividends paid or previous withdrawals. What you have paid in you already paid income tax on, therefore they won’t be taxed again when you withdraw them from the policy.

You will have to pay taxes on earnings above your cash basis of the policy. Let me explain, if you have a cash value life insurance policy with a cash value of $18,000. If your basis in the policy is $12,000, you can withdraw this amount without any tax penalty. Any amount above this you will have to pay income tax at ordinary income rates, not at capital gains rates.

Surrender charges may apply when you make a withdrawal. A smart way to avoid this is to take a policy loan from the insurance company, using the cash value in the policy as collateral. If you repay the loan the amount you borrow is generally not treated as taxable income, and there are no surrender charges. You will have to pay interest on the loan, which is not tax deductible.

Does borrowing against my Life Insurance Policy reduce its value? I need some funds to cover an unexpected expense, but do not want to affect my policy’s value.

Thanks, Ritchie

Thanks for your question, Richie. It will not if the loan is repaid. Whole life, universal life and variable life insurance policies unlike term life insurance have a savings component which is also known as “cash value”. Policy holders may withdraw or borrow against the cash surrender value of their policies. A heads up however, if you withdraw from your policy even if it is just to the basis you may be obliged to pay surrender charges, and withdrawn earnings over the basis are liable for income tax.

Taking a policy loan using the cash value as collateral is one way to avoid surrender charges and still be able to access the money. As long as you repay the loan, the amount is not considered taxable income. You will have to pay interest on the loan which is not tax deductible.

If you have any outstanding loans against a Life Insurance Policy collateralized with the cash value of the policy, your death benefit is reduced to cover the loans. It will reduce the cash surrender value of the policy to have a loan as well should the policy be canceled before you pass.

If a policyholder loan is not repaid by the policyholder while he/she is alive, it will be taken from the distributed proceeds to the survivors and beneficiaries. Good luck with your financial situation. Be sure to consult with your insurance agent to review the specifics of your policy if you have any further questions.

Reader Question:

What are the consequences of surrendering my Life Insurance Policy? I’m very confused; will you explain this to me? Thank you, Deana

Thank you for your question, Deana.  When you surrender your Life Insurance you are  canceling the policy altogether. In these difficult economic times you may consider liquidating assets for cash; you may think you have no other choice. Ask yourself first if you still need the coverage and whether your  beneficiaries would be dependent on the death benefit if you were to pass away?

Consequences of surrendering insurance

When you surrender your policy to get the cash, you understand that you are giving up the right to the death-benefit protection of the insurance. It may be harder or more expensive to get the same coverage later. Also the gain on the policy is subject to income tax when you surrender the policy for cash, and additional taxes may be incurred if you have an outstanding loan balance against the policy. If yours is a cash value life insurance policy and you surrender it, you may be subject to a taxable gain if the policy’s total cash value exceeds the cost basis of the policy.

Whole life, universal life and variable life insurance policies have a savings component which is also known as “cash or surrender value” or policyholder’s equity”. Life insurance policy holders may borrow against the cash surrender value of the policy and if yours is a non-MEC (modified endowment contract) policy it isn’t taxable, and you won’t have to make payments on the loan even though your loan balance might be gaining interest.

Other options to consider

You might be wise to borrow against your 401K, or take out a home-equity loan instead. Of course there are issues to consider with these choices as well, but depending upon your current needs and circumstances, some choices may be better than others.

Check with your agent to find out what is and isn’t allowed with your policy. This decision should only be made after due consideration of all the facts and options. I trust this has helped to simplify your decision, Deana.

There are different types of insurance that will meet your needs depending on what you can afford.

Term Life Insurance

Term Insurance is the most basic and relatively least expensive. It is a policy over a specified period of time, over 1 to ten years, and once it lapses you could always renew it if you want to continue the coverage. Declining Balance Term Insurance on the other hand is used as mortgage insurance where the policy could match the amortization of your principal mortgage. Term insurances are strictly insurance and not an investment vehicle. When buying for term life insurance, look for companies that provide renewable and convertible policies.

Whole Life Insurance

Whole Life Insurance is  permanent protection. This one is an investment tool for you. You have lock-in coverage as long as you are able to pay the premiums. Your policy gains value in whole life insurance and so you could borrow up to ninety per cent of your policy’s cash value tax free when needed.

If you already know what type of insurance to get, the next question is how much coverage do you need? This depends on how much you earn, your total mortgages and loans plus interest and the number of children you have for which you want to secure a college education.

Yes, a life insurance policy is a necessity but you do not need to rush to make a decision. Study the types of insurance thoroughly and see which ones work best according to the needs of your dependents if you should leave them unexpectedly.

If you are young and just starting your family and estate and find yourself strapped for cash, then term insurance would be worth considering . Once your income has increased and is more stable, your might want to switch to Whole Life Insurance as the premiums are level and it has no expiration date; also it establishes cash value.

Policy reserves

Part of the premium is transferred to form policy reserves, to fund what would otherwise be an insufficient premium in later years. For all permanent insurance contracts, this serves as a basis for determining life insurance premiums for every policy holder.

Cash surrender value

If a policy holder decides to end this permanent, whole life insurance policy, the insurance company will return the equitable share of the accumulated policy reserve to the policy holder. This accumulated policy reserve is called the policy’s cash surrender value. The life insurance provider will then be released from its financial obligation to the policy holder in the future.

In the first to two years of signing a purchasing a policy from life insurance provider, the cash surrender value is not yet available since the period is too short to earn interest for the insurance company to compensate the cost of putting the policy in force.

Unchanging premiums of whole life

With a whole life insurance policy, the premiums are paid at the same amount yearly from the date the policy is issued until the death of the policy holder. The policy holder may requests to terminate paying the premiums every month and surrenders the contract policy for its cash value. Another option is to take extended term or reduced paid-up insurance.

If you want  lifetime protection and protection of the assets,  for retirement purposes, burial expenses, or cash funds for the dependents when the policy holder dies, a whole life insurance policy is the best choice.