Is a Cashed in Insurance Policy Taxable?
A life insurance policy protects your family from your financial obligations after you die. But you may not want or need your insurance policy after a certain age. You may opt to cash in your policy, which can trigger an unwanted tax liability. Make sure you understand the rules surrounding the taxation of life insurance before you surrender your policy.
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Type
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Only cash value life insurance policies are subject to income tax when you surrender the policy. A cash value life insurance policy builds a cash reserve against the value of the death benefit. This cash reserve functions as a savings during your lifetime, however, and may be used as such. Examples of cash value policies are whole life, universal life and variable life insurance.
Significance
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When you cash in a cash value policy, you must pay income tax when the cash value in the account exceeds the total of all of the premiums paid into the policy. The total premiums paid is called your cost basis. Your cost basis in the policy represents your investment principal.
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Prevention
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You must pay income tax on your cash value if you surrender the policy, but you should consider keeping the policy. This will prevent you from having to pay income tax on your policy. Instead, you may take policy loans. A policy loan is loan against the value of the insurance policy. The insurance company secures the loan with money in your policy. It charges interest on the loan, but the insurer often credits your insurance policy with interest on the cash value so the loan interest may amount to a low net or zero percent cost to you.
Consideration
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Consider transferring your policy to an annuity insurance policy if you just don't want the contract. An annuity insurance policy is a savings plan with an insurance company designed to help you build a retirement savings. A 1035 exchange allows you to transfer the cash value of a life insurance policy to an annuity account without paying income taxes. This allows you to get rid of the policy but keep the savings intact.
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