Tax Consequences When Cashing Out a Life Insurance Policy
Life insurance policies are generally income tax-free. If you own a cash-value life insurance policy, however, you have to take into consideration some tax consequences if you cash out your policy for the cash-surrender value. Cash-value insurance is subject to very specific rules by the IRS, and you need to follow them so that you do not end up with penalties for not paying the required tax.
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Non-forfeiture values
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The non-forfeiture values of the policy are generally income tax-free. This is provided that they remain inside the policy. As the cash values build up, you don't need to even report these values on your 1040 tax return.
Taxes on Death Benefits When Cashing In Your Policy
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When you cash in your policy, the death benefit is generally not considered a gain. As such, you will not be charged any tax on the death benefit unless you accessed any accelerated death benefit options in the policy. If you accessed accelerated death benefit provisions, you may be taxed at ordinary income tax rates if you sell your policy to a life settlement company as part of the surrender of your policy or if you exceed the accelerated death benefit per diem rates specified by the IRS.
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Taxes Due on Surrender
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If you surrender your life insurance policy, any cash values that represent a gain will be taxed at ordinary income tax rates. A gain in the policy will be any cash value that exceeds the premiums you've paid into the policy.
Misconceptions
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One misconception about the tax consequences of cashing in a life insurance policy is the idea that you are assessed at capital gains tax rates on any gain of the cash values. This is not true. The IRS has made it clear that cash values are taxed at ordinary income tax rates
Considerations
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Before you cash in your life insurance, you should consider if it makes sense to do so. Because you may be subject to taxes on surrender of your policy, you might want to consider withdrawing or using policy loans to access the cash value. To prevent the policy from lapsing, you may need to convert the policy to a reduced, paid-up policy, if that option is available.
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References
- http://www.irs.gov: Taxable and Non-Taxable Income
- Life & Health Insurance, License Exam Manual, 6th Edition; Dearborn Financial; 2004
- "Ernst & Young's Personal Financial Planning Guide, 5th edition"; Martin Nissenbaum, Barbara J. Raasch, Charles L. Ratner; 2004
- http://www.irs.gov: Tax Treatment of Life Insurance Cash Values
- http://www.irs.gov: Per Diem Accelerated Benefits Exception
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