Do you pay taxes on the cash value of a life insurance policy when you cash it out?
Cash value life insurance is a type of life insurance that provides a cash-surrender value along with the death benefit.
The cash-surrender value is a cash reserve that builds against the value of the death benefit.
The difference between the cash value and the death benefit is called the "net amount at risk," since this is the dollar amount that needs to be paid out by the insurance company when the person insured by the policy dies.
As this cash reserve accumulates in the policy, the "net amount at risk" decreases.
In other words, the cash value replaces the death benefit over time.
During your lifetime, however, you may cash in your life insurance policy to receive the cash-surrender value. This may have tax implications, however.
Cashing in your cash-value life insurance policy involves telling the company you want to terminate your policy. The company will send you forms for surrendering your policy.Alternatively, you may withdraw or borrow the full amount of your policy so that the policy lapses.
The insurer may send the money to you within a week, but many states allow the insurer up to 30 days. Either way, the policy proceeds can be used to meet whatever financial need you have at the time.
When you cash in your policy, you lose your life insurance protection, creating financial hardship for your family if you die and are uninsured. You may also create a tax liability by cashing in the policy. If your policy's cash value exceeds your basis, or the total amount you've paid in as premiums, then you'll pay income tax on that amount.
Instead of cashing in your life insurance policy, consider borrowing against the policy. Policy loans are tax-free. If you leave your policy in force, you'll never have to repay your policy loan and you won't ever be taxed on the amount you borrowed. Policy loans are considered "open" until your death.
This means that your life insurance policy loan does not need to be repaid during your lifetime. Instead, the insurance company deducts any unpaid loans from your death benefit when you die and pays the remainder of the death benefit to your beneficiaries.
Even though policy loans are "open" until your death, most insurance companies charge interest to your cash value account on policy loans. Because of this, you'll need to make sure the policy's remaining cash value generates sufficient interest to pay for the loan interest or that you tell the insurer that you want to pay the interest on the loan yourself instead of having it charged to the policy.
If you fail to pay the policy interest, or the cash value does not earn sufficient interest to pay for the loan interest, the loan interest could cause the cash value to become depleted. Eventually, the policy lapses if the interest causes the cash value to fall to zero. When this happens, all policy loans are forgiven and treated as income. Additionally, when your policy lapses, gains in the policy (money in excess of the total premiums you've paid) are subject to ordinary income tax.