Is life insurance taxable?

When is cash value of life insurance taxable

It is not typical for accessing more than the policy base to trigger large tax bills. So it is worth learning how and when this could happen. These are the three scenarios to watch out for:

You can cancel the policy.

You can surrender your permanent life insurance policy to cancel the coverage. The insurer will pay the policy’s cash amount with fewer surrender fees. Taxable is the portion of the cash value above the policy basis. If you surrender a policy worth $10,000 and the policy base is $5,000, the IRS will tax the $5,000 additional income as income. The investment gains from the policy are reflected in the taxable amount.

You can sell the policy.

You can make more money selling your life insurance policy, also known as a life settlement. The policy’s price is not limited to the cash value but is determined by other factors such as your life expectancy and death benefit, as well as the cost of the premiums.

The IRS levies two types of taxes on life insurance policies. They are both based on your profits.

The cash value above the policy base is subject to income tax.

Capital gains tax will be due on all other profits, including money received that exceeds the policy’s cash value.

Let’s say you want to cancel your life insurance policy to buy another one. You may wish to trade it in a 1035 exchange, a U.S. tax law provision allowing you to swap similar properties without capital gains tax.

You can take out a loan against the cash value.

Cash value loans are exempt from tax even if you borrow more money than the policy base. You can borrow against your life insurance policy tax-free as long as it is repaid. However, if you default on repaying the loan, there could be severe tax consequences.

Let’s say your policy has a $10,000 cash value, and your policy basis is $5,000. This means you have paid $5,000 in premiums. You won’t be taxed on $9,000 more if your policy is active. However, as interest accrues on a loan, your debt could become more significant than the cash value. You must repay the loan, or your insurer can cancel the policy.

Insurers usually use the cash value to repay loans if they cancel a policy. You pay tax on any excess. This is where you could run into problems. You could not only refund the loan but also have a large tax bill.

You should note that any remaining amount is deducted from the death benefit if you die before paying off your loan. This means that your beneficiaries will receive less money.