Do I Need to Pay Tax on Withdrawals From a Whole Life Policy?
Whole life insurance policies that allow withdrawals are dividend-paying whole life policies. Cash values in whole life policies are normally not available for withdrawals since the cash value represents money invested by the insurance company. When you withdraw money, you may withdraw dividends, since these dividends represent money that is already earned and used to buy additional insurance that is paid up in full.
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Process
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When you withdraw money from your whole life insurance policy, you must surrender your dividends in the policy. The dividends have a cash value associated with them. The surrender of the dividends results in the dividend being converted to cash. The amount of cash you receive is equivalent to the cash value associated with the dividend in the policy. When you surrender dividends in your policy for cash, you reduce the death benefit of the policy, along with the available cash value.
Basis
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Your basis in your whole life insurance policy is tax-free. Your basis represents the total of all premium payments you've made to your whole life insurance policy. This means that when you make a withdrawal, you may withdraw an amount of money (in dividends) that is equivalent to all of the money you've paid in as premium payments without paying tax on the withdrawals. Any amount of money in excess of your basis is subject to taxation.
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Tax Due
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With an ordinary investment, cashing in some or all of the investment is considered a capital gain. However, dividends from a whole life insurance policy are taxed at ordinary income tax rates. In other words, dividends are considered investment income. This income is added to your gross income from all other sources and is reported on your tax return under investment income. Only dollar amounts in excess of your basis are subject to income tax.
Consideration
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When you withdraw money from your whole life insurance policy, you cannot redeposit it, like you would with an investment account. Your cash value and death benefit are permanently surrendered and decreased by the amount you withdraw. Instead of withdrawing money from your policy, consider a policy loan. A policy loan allows you to keep the current death benefit and cash value intact. Instead of withdrawing, you take out a loan against the value of the policy. This loan does not need to be repaid during your lifetime. Policy loans reduce the amount available for withdrawal or future borrowing. However, if you do repay the loan, the policy will be restored to its original value since no money was actually withdrawn.
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References
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