The taxability of life insurance cash surrender value causes much confusion. Agents often extol the tax free nature of life insurance. But the marketing brochures often have numerous footnotes on the tax subject.
So is your the cash surrender value of life insurance taxable? The answer is yes. The answer is also no. The truth is asking simply: “is my life insurance cash surrender value taxable?” isn't the right question.
The right question is: “when is the cash surrender value of life insurance taxable?”
As a general rule of thumb, when cash value remains inside a life insurance contract, it is not taxable. This means that as cash value grows inside a life insurance policy, you will not owe taxes on the interest or dividends earned on this cash value. The key feature, is that everything remains inside the policy.
Notice that in the example above life insurance taxability is different from ordinary savings account. If Wendy earns $4,000 on her savings account this year, she will need to report the interest earnings as income when she files her taxes. She will then owe ordinary income taxes on the $4,000 interest payment.
Because the interest earnings remain inside the life insurance policy, Wendy does not owe taxes on it. Wendy can compound her cash surrender value growth through the interest payments and she will owe no taxes on the interest payments so long as the cash value remains in the policy.
Using the paid-up additions option with the dividend payment keeps the money inside the policy and Harold owe no taxes on the dividend payment.
There are two ways to take money out of a life insurance policy while it remains in force. First, one can withdraw cash through a partial surrender. Second, a policyholder can take a loan against the life insurance policy. Let's explore the taxability of these actions.
Life insurance enjoys many tax-favorable treatments. One beneficial tax treatment of life insurance is the First In First Out (FIFO) accounting principle. FIFO allows the policyholder to recoup his/her contributions to the policy before he/she must remove gains from the policy.
The $50,000 is non-taxable to Emanuel because he is removing part of his contributions to the policy (the $150,000 he paid in premiums).
Because of the FIFO rule, life insurance policyholders can withdraw money from their policies up to the amount they put in and pay no taxes on the distribution. This is because they are technically taking back the dollars they put into the policy.
The alternative to FIFO is Last in First Out (LIFO). Under this accounting rule, the account holder must first remove any gain before he/she can remove contributions (also known as cost basis). Using the example above, if Emanuel withdrew the money from an account that uses LIFO, he would owe taxes on the $50,000 distribution because the account currently has a $350,000 gain.
Luckily, all life insurance policies use FIFO accounting rules.
Doing this, Emanuel will owe taxes on $50,000. He owes no taxes on $150,000 of the withdrawal because that is his cost basis in the policy. The $50,000 remaining is part of the gain he achieved with the policy and he'll owe ordinary income taxes on this sum.
Any amount withdrawn above the cost basis of a life insurance policy is taxable as ordinary income. If Emanuel canceled the entire policy, he'd receive $500,000 in cash from the life insurance company. He would also owe taxes on $350,000.
As I already mentioned, you can also use a life insurance policy loan to take money out of a policy. Actually, a loan doesn't remove money from your policy. What technically happens is a pledging of the money in the policy as collateral for a loan issued by the life insurance company to the policyholder. The cash in the life insurance policy never leaves the policy.
Because the money never leaves the policy and because the IRS does not view loans as income (in most cases) the life insurance policy loan is a non-taxable event. This is true even when generating a loan that goes beyond the cost basis of the policy.
Taking the distribution from the policy in this fashion completely avoids any taxability to Emanuel. He withdraws his basis, which is nontaxable to him. He then takes a loan for the remaining $50,000, which also has no taxability to him.
Life insurance policyholders can use loans on cash surrender value to avoid taxes without needing to withdraw any money. From the example above, Emanuel could simply take a loan for $200,000 and he'd have no tax liability. The decision to take a withdrawal versus a loan can be complex and we'll address it in more detail in another blog post. I simply want to point out that one doesn't necessarily have to withdraw money up to his/her basis first before taking a policy loan.
If using a loan, you must understand that the tax-free nature of the loan only remains tax-free if the life insurance policy remains in force. If you cancel a life insurance policy with an outstanding loan, you will owe taxes on any gain on the policy.
Emanuel receives $300,000 in cash from the life insurance company. This is his cash surrender value after repaying the loan. He will owe taxes on $350,000 because of the $50,000 he already distributed from the policy through a policy loan.
It is possible, though not very common, to cancel or lapse a life insurance policy with significant outstanding policy loans. In this situation, the taxes due may far exceed any remaining cash value received upon policy termination. For this reason, policyholders should take some cautions to ensure canceling a policy will not cause substantial tax liability due to outstanding loans on the policy.
It's also important to know that if the policyholder dies, the taxability of the distributions through policy loans goes away. Because the policy ended up paying a death benefit, there is no tax liability on the outstanding policy loans. The insurance company will use a portion of the non-taxable death benefit to pay the outstanding policy loans and the remaining death benefit will go to the beneficiary(ies).
The Insurance company will pay off his outstanding $200,000 loan with a portion of the $1 million death benefit. The remaining death benefit amount of $800,000 will go to his beneficiary(ies). There is no tax owed either by Emanuel or his beneficiary(ies) despite the outstanding loan that distributed $50,000 of his policy's gain.
There are times when people wish to buy new life insurance. There are also times when people wish to buy new life insurance and transfer the cash surrender value of their old policy into this new policy. Thankfully, tax law does allow for a very tax-efficient mechanism to accomplish this.
The 1035 exchange allows a life insurance policyholder to transfer the cash surrender value of his/her policy into a new life insurance or annuity policy without owing any taxes on the gain of the policy.
If the 1035 exchange didn't exist in U.S. Tax Code, then anyone wishing to buy a new policy and moving cash in his/her old policy to the new policy would need to:
Luckily none of this is necessary, as policyholders can simply move the money from an old policy to a new one through the 1035 exchange. Policyholders can also transfer their cost basis from the old policy to the new policy. This might have strategic tax benefits.
But you shouldn't assume that just because you have cash surrender value in your old policy, you have to use a 1035 exchange when buying a new policy.
If the old policy has no gain, then the 1035 exchange's tax-free transfer feature is moot. You wouldn't owe taxes when canceling your old policy because you've paid more in premiums than you have in cash surrender value.
I want to point out that the examples above specifically speak to life insurance. If you have a policy that violated the Modified Endowment Contract Test then you have a contract with very different rules concerning the taxability cash surrender value.
Brandon launched the Insurance Pro Blog in July of 2011 as a project to de-mystify the life insurance industry. A specialist in the design and application of life insurance cash accumulation features, Brandon is one of the foremost authorities on the subject of coordinating life insurance cash values in a financial plan.