What Taxes are to Be Paid With a Surrender of Variable Universal Life Insurance?
Variable Universal Life insurance is a type of life insurance that offers elements of insurance and traditional investments like mutual funds. This combination results in the product being taxed differently from ordinary investments. Make sure you understand how variable universal life is taxed if you surrender your policy. Otherwise, you might be in for a big surprise.
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Features
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A Variable Universal Life insurance policy, sometimes referred to as a VUL, combines an annual renewable term life policy with an investment in mutual funds. Premiums are invested in mutual funds of your choice. The profits are then credited to your cash value account. The policy's term insurance component is paid out of the cash value account.
Tax
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Unlike ordinary mutual funds, VUL mutual funds are not subject to taxation as long as the policy remains in force. If you surrender the policy, however, you will pay tax. You won't pay capital gains tax. Instead, you will pay ordinary income tax. This is because the gains are treated as gains from an insurance policy, not from an investment.
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Significance
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By paying ordinary income tax, you may increase the tax burden on all of your other income. This is because the gains from your VUL policy are added to the rest of your gross income. If the gains increase your total income such that you are put into a higher marginal tax rate, your average tax rate (the actual amount of tax you pay) will increase. This will result in you receiving far less from your policy after you surrender it than you may have originally expected to receive.
Prevention
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To avoid having to pay income tax, you have a few options. You may keep the policy and take policy loans from it. Policy loans are tax-free as long as you keep the policy in force. May insurers also offer preferred policy loans with a net cost of zero percent. You may make withdrawals from the policy. Withdrawals up to your cost basis (the total amount of premiums you've paid) are tax-free. Finally, you may transfer the funds from a VUL into an annuity. This is called a 1035 exchange. If you are looking for a more stable product with consistent returns, a fixed annuity may be used and the exchange will not trigger the payment of income tax. You will, however, have to pay income tax when you withdraw money from the account.
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