Life insurance policies provide protection for your family in the event of your death. You may wish to cancel your policy, however, if you no longer need the policy. If this is the case, you need to know what happens to your policy, as there may be significant tax implications for you.
Term Life Insurance
Term life insurance is basic life insurance protection. This type of insurance offers a death benefit in exchange for a premium payment. There's no value outside of the death benefit of the policy. When you stop paying premiums, the policy terminates. These policies may also contain provisions giving you the option, but not the obligation, to convert the policy to a permanent policy.
Cash Value Life Insurance
Cash value life insurance is the broad name for all whole life, variable life and universal life insurance policies. These policies build a cash reserve, called a cash value, that's associated with the policy. This cash value functions as a tax-free savings as long as the policy remains in force. The cash value may be borrowed against, or a withdrawal may be taken from the policy.
There are no tax ramifications when term life insurance is canceled. Instead, the policy simply stops providing coverage. Cash value life insurance is another story entirely. Because cash value insurance builds a savings, this savings is taxed. Any gain in the policy is taxed at ordinary income tax rates. This means that any money in excess of the costs for the policy are taxed. This could be substantial if you've held the policy for a long time.
Consider keeping the policy if you have a cash value policy. Taking withdrawals up to an amount that equals the premiums you've paid in so far is tax-free. Policy loans are tax-free. If you just don't want the policy anymore, consider exchanging the life insurance policy for an annuity. A 1035 exchange allows you to purchase an annuity policy, which is a long-term savings vehicle sold by an insurance company, without paying income tax on the transfer. Your cash value is deposited into the annuity, and your death benefit ceases to exist.