What Are The Tax Consequences Of Surrendering A Life Insurance Policy
In terms of tax on the surrender of a life insurance policy, it actually is not viewed much differently from regular income, so its subject to a marginal rate of taxation. If a policy ends after 20 or more years, the cash return is likely to be much higher. However, if the policy has only been in place for 10-15 years or less, your provider may issue surrender fees, similarly to if you were to pull out of an investment. If youre unsure about these fees, your broker will be able to set expectations and let you know where your policy currently stands.
Cancelling a life insurance policy you no longer want or need can be an excellent way to put extra cash in your pocket. You may need this money for cost of living increases or even to fund a long-dreamed of vacation.
For example, lets look at the tax implications of cashing out a whole life policy for you as the policy holder. When you cash out the whole life policy the money you receive in return may be taxed over a certain threshold.
Create An Emergency Fund
If youre living from paycheck to paycheck, an emergency fund could take some of the pressure off. You should have between three and six months worth of living expenses in your emergency fund to cover your cost of living if you lose your job, your car breaks down or you become ill and unable to work.
When You Sell A Life Insurance Policy
If you decide you no longer need permanent life insurance and want to sell it , keep this in mind: The agent or broker selling it on your behalf will take a cut from the amount you receive.;And don’t expect to get back the amount you’re covered for when you die;. You’ll get back;less;than that, and if the amount you do receive totals more than all the premiums you’ve paid over the years, you’ll pay income tax on it.;
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You Withdraw Money From Cash Value
If you have a cash value life insurance policy, you can generally access the money through a withdrawal or loan, or by surrendering the policy and ending it.
One of the reasons to buy cash value life insurance is to have access to the money that builds up within the policy. When you pay premiums, the payments generally go to three places: cash value, the cost to insure you, and policy fees and charges. Money within the cash value account grows tax-free, based on the interest or investment gains it earns . But once you withdraw the money, you could face a tax bill.
Money thats withdrawn is generally made up of two parts:
- Money that came from premium payments you made. This component of a withdrawal is not taxable. In the life insurance industry this part is called the policy basis.
- Money that came from interest or investment gains. This portion is subject to income taxes. Your life insurance company will be able to tell you what amount in a withdrawal is above basis and taxable.
If your life insurance policy is a modified endowment contract, or MEC, different tax rules apply and its best to consult a financial professional to understand tax implications.
Exploring Basis Vs Profit
After establishing the basis value of your policy, you will need to identify the current cash-surrender value. You can consult with your life insurance provider to determine what the current cash-surrender value of your policy will be. With this sum in mind, you can subtract the basis you calculated earlier to identify the exact amount of profit you will earn in the event that you complete the cashing out process.
It is critical that you take the time to incorporate any and all withdrawals or dividends received from the policy prior to cashing out, as this information can significantly affect the total amount of tax you will end up paying on the money you receive. As could be expected, the less profit you earn from your policy, the less tax you can expect to pay.
In the event that your basis is larger than the cash-surrender value of the policy, you will still receive the cash-out amount but will not be required to pay any tax on these funds. This is due to to the fact that you have technically earned no profit from cashing out the policy.
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Tax Rates On Distributions
If some of your cash out of your life insurance policy is taxable, you pay taxes on that income at your ordinary income tax rate. For example, if $3,500 is taxable and you fall in the 15 percent tax bracket, you pay an extra $525 in income taxes that year. Even if the money in the life insurance policy was held in stocks or other assets that qualify for the lower long-term capital gains tax rates, your distributions always count as ordinary income.
Using Life Insurance Policy Loans To Avoid Taxes
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 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.
Are Life Insurance Proceeds Taxable Cases In Which Life Insurance Is Taxed
Life insurance proceeds are typically not taxable as income, but can be taxed as part of your estate if the amount being passed to your heirs exceeds federal and state exemptions. You may face income and capital gains taxes if you decide to get rid of your policy through a life insurance settlement or by surrendering it to your insurer.
Tax Consequences Of A Disposition
A cash value withdrawal and a policy loan are dispositions of an exempt policy. A collateral assignment of a policys cash value to a lender as security for a loan is not a disposition.
At the time of a disposition, the proceeds of the disposition that are in excess of the policys adjusted cost base are a taxable policy gain. This amount, if any, is reported on a T5 slip by the insurer. It is ordinary income, like interest income,;not;a capital gain. If realized by a corporation, this income is considered passive investment income.
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How Do You Pay The Taxes
Your insurance provider may give you the option to have taxes withheld. If not, you will need to make an extra tax payment to the IRS.
You can typically pay the taxes owed when you file your tax return. However, you should be aware of the estimated tax rules. There are some cases where you may need to make a tax payment by the end of the quarter to avoid paying interest if you wait until you file to pay.
The taxable portion of a life insurance policy cash out is ordinary income subject to the same income tax rates as your wages, investment income, and other taxable income. Use a tax calculator to check your withholding, figure out how much money to set aside for taxes, or to check if you need to make an estimated tax payment.
The Taxation Of Receiving A Life Insurance Policy Loan
One of the more popular features of permanent life insurance with a growing cash value is the fact that the policyowner can borrow against the policy without incurring any tax consequences. By contrast, as noted above, surrendering the policy could cause a taxable gain .
In reality, though, the tax-favored treatment of a life insurance policy loan is not actually unique or specific to life insurance. After all, technically a life insurance policy loan is really nothing more than a personal loan from the life insurance company, for which the cash value of the insurance policy is collateral for the loan. The fact that the life insurance company has possession and controls that policy cash value allows the company to be confident that it will be paid back, and as a result commonly offers life insurance policy loans at a rather favorable rate .
Accordingly, the cash from a life insurance policy loan is not taxable when received, because no loan is taxable when you simply borrow some money! Just as its not taxable to receive a credit card cash advance, or a business loan, or the cash from a cash-out refinance, a life insurance policy loan is not taxable because its simply the receipt of a personal loan.
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Offering You Peace Of Mind
Many permanent life insurance policies allow the investments held in the policy to grow without being subject to annual tax payments on gains on those investments. Although there are some limitations, this feature allows you to potentially shelter a substantial amount of cash value from accrual taxes within the policy.
You might access the cash value of your life insurance policy for any number of reasons, including: taking advantage of personal or practice opportunities, helping to fund your childrens education, boosting cash flow in retirement or dealing with unforeseen financial emergencies.
While you may not intend to use the accumulated cash value of your permanent life insurance policy, you gain security and peace of mind knowing that the funds are available if you need them.
Life Insurance Distributions Following Death
Life insurance distributions following the death of someone else are not taxed.
- If a beneficiary receives a distribution from your life insurance plan upon your death, he does not have to pay income tax on it.
- You can request that the beneficiary use some these funds to help cover your end-of-life expenses, such as your funeral, or you can allow him to use the funds as he desires.
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You Took Out A Policy Loan And The Life Insurance Ends
If you have a policy with cash value and take out a loan against it, the loan isnt taxable as long as the policy is in-force. But if the policy terminates before youve paid the loan back, you could get a tax bill. For example, if you surrender the policy or it lapses, the coverage terminates.
The taxable amount is based on the amount of the loan that exceeds your policy basis. Remember, policy basis is the portion youve paid in as premiums. Amounts above basis are based on interest or investment gains on cash value.
One way to access all your cash value and avoid taxes is to withdraw the amount thats your policy basis this is not taxable. Then access the rest of the cash value with a loan also not taxable.
Options Besides Surrendering The Policy
You may also have the ability to exchange your current policy for another insurance policy. This is known as a 1035 exchange, which can be done tax free and get you in a better policy more suited to your needs.
This exchange may allow you to use the cash value to buy different type of insurance, or buy a policy that has additional features that are more appropriate for you. For example, if cashing out the policy is not feasible, you may want to consider a life insurance policy with a long term care rider that could allow you to use that cash value in the future to pay for long term care costs.
The image above is a slide from a webinar we did for clients about long term care. If saving or paying for future long term care is a priority for you, watch our webinar here.
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This Matters When It Comes To The Impact Of Taxes
If you are wondering is cash value of life insurance taxable in Canada its important to determine what TYPE of life insurance you are talking about.;
There are two different types of life insurance you can buy. Term, which is temporary income protection that is meant to cover you during your most vulnerable years. There is no guarantee that your beneficiary receives a payout so its VERY affordable.;
To be honest term works for most people most of the time BUT there are those of us that want to guarantee a payout and thats where Permanent life insurance comes in.;
Permanent Life Insurance provides coverage until the day you die and often includes a cash accumulation feature. THIS is where taxation can come in.;
Cashing Out Permanent Life Insurance
In some cases, you can take distributions from your life insurance before you die.
Typically, you can only take pre-death distributions from permanent life insurance policies, and you must report some of the distribution as a capital gain. To calculate capital gains, you start with the proceeds of distribution and then subtract the Adjusted Cost Base of the asset. In most cases, the ACB is the amount you paid for the asset.
Many people erroneously assume the ACB in this case is the amount you have paid for your premiums over the years. Some of your premiums are an expense directly related to the privilege of having life insurance, and as a result, they cannot be used to calculate your ACB. Instead, you need to take the amount of premiums paid minus the value of insurance to determine your ACB.
For example, imagine you have taken a $150,000 distribution from your whole life policy, and over the years, you have paid $50,000 in premiums. According to the T5 slip issued by your insurance company, $10,000 of your premiums were simply related to the cost of being insured. As a result, you subtract $10,000 from $50,000 to find your ACB of $40,000. Subtract this amount from your distribution of $150,000 to arrive at your capital gain of $140,000.
References & Resources
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The Life Insurance Payout Goes Into A Taxable Estate
Most life insurance payouts are made tax-free directly to life insurance beneficiaries. But if a beneficiary was not named, or is already deceased, where does the life insurance death benefit go? It goes into the estate of the insured person and can be taxable along with the rest of the estate.
This could create a significant tax bill, especially considering both federal and state estate taxes. While federal estates taxes will not tax the first $11.7 million per individual , state estate taxes can have significantly lower exemption levels.
Another possible unhappy scenario is that an estate is below the exemption level but a large life insurance payout into the estate pushes it above the exemption threshold into taxable territory.
This should all be avoidable by naming both primary and contingent life insurance beneficiaries, and keeping those selections up to date.
Calculating Life Insurance Policys Cash Surrender Value
There are several factors that go into calculating the cash surrender value in your policy. The key factors include:
- How long the policy has been in force and the total amount of premium that you have paid into the policy
- The amount of interest, dividends or capital gains that have been earned by the cash value in the policy
- The amount of cash surrender fees and charges that the insurance company will assess in order to liquidate the policy. These charges can remain in effect for as long as 10 or 15 years after purchase in some cases. Once this period of time has elapsed, the policy cash value will equal the cash surrender value.
If your policy is relatively new, then youll probably get little or no cash value if you cancel your coverage, because your cash value hasnt had much time to accumulate, and the life insurance company will most likely assess a surrender charge on any amount that you receive.
The amount of cash value that you receive will always be substantially less than the policys face value.
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Permanent Life Insurance Taxes
For the most part, life insurance premiums are non-deductible.
Life insurance death benefits are tax-free.
Permanent life insurance is long-term and lasts up to 100 years. It is fairly expensive yet offers much more potential for growth.
Premiums are higher for this kind of coverage for a number of reasons, including the fact that they fund a reserve. The reserve assists with future premium payments.
A reserve is invested by the life insurance company, and the money that grows in this bucket does so on a tax-deferred basis. The growth can be used for future premiums and mortality costs.
This is ideal since mortality costs increase as policyholders get older.
An exempt policy defers taxes. There are rules that decide whether a policy falls into this category, but almost all permanent policies in Canada are exempt.
Find The Cheapest Insurance Quotes In Your Area
And what if youre in a situation where you no longer need life insurance? If you have very little debt and no dependents, you may not need to maintain a policy at all. In this case, you shouldnt keep paying for a whole life insurance policy unless its part of a well-considered estate plan. If you dont need the policy anymore, call your insurance company to cancel it. Again, you can take the cash benefit your pocket and invest it for the future.
Whole life insurance policies are the best option for some people, especially those who will always have dependents due to disabilities and the like. But if youre paying for an expensive policy you dont really need, cashing out may be the best option, even if you have to pay fees and taxes. Just be sure you know exactly what those expenses will be before you initiate the process.
Finally, whole life and universal life policies can be extremely complicated. Any decision you make may have tax implications. The key is to seek the advice of a qualified life insurance specialist before making a decision.
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