Taxes When Cashing Out a Life Insurance Policy
One of the touted benefits of life insurance is that it is generally exempt from income taxes. This is true as long as the policy stays in force. However, if the policy lapses for non-payment of premiums, there could be significant tax consequences. Surrendering a policy refers to cashing it out. This involves calling the insurance company and filling out a form (if required by the company), then collecting and cashing a check for the cash surrender value.
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Determining Basis
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The basis in your life insurance policy represents the amount of premiums you've paid into it. This is easy to determine because insurance companies list your premium payments on every life insurance illustration. A life insurance policy illustration is a small booklet providing essential details about your policy, including how much your premiums are on a month to month basis. All you need to do is add up all of the premiums you've paid so far. Your policy illustration will tell you when you first started making premium payments and will also list a summary of all scheduled payments.
Cashing in Your Life Insurance Policy
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Surrendering your life insurance policy involves calling up the company or contacting your life insurance agent and asking for any forms necessary to cash out its value. Once all of the necessary paperwork is in order, you will receive a check for the cash surrender value of the policy.
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Reporting Gain on Your Taxes
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Any realized gain in the policy will be the difference between the cash surrender value of the policy and the policy's basis. You will pay ordinary income taxes on this gain reportable on your 1040 tax return.
Misconceptions
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A common misconception is that life insurance cash values are taxable as capital gains when you cash in your policy. This is untrue. Cash values are taxable as ordinary income and reportable on your 1040 tax return. Additionally, taxes on your cash value are only due when the policy is surrendered and there is a gain in the policy.
Considerations
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Before you cash in your life insurance policy, consider the option of cashing in only part of your policy and converting it to a reduced, paid up policy. Many insurance companies offer this option which will not cause your policy cash values to be subject to income tax.
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References
- Photo Credit tax forms image by Chad McDermott from Fotolia.com
