How to get life insurance. Articles - Tax Consequences of Making Changes to or Cancelling a Life Insurance Policy

Over time, and as circumstances change in your life, you may no longer want to keep making monthly payments into life insurance, and it may be beneficial change your current policy. This article provides a general background of the various considerations, including tax consequences, of modifying, selling, or cancelling your life insurance policy. Life insurance cost.

There are two major categories of life insurance. The first are protection policies, called term insurance. These policies provide coverage within a set time range, and pay a lump sum if the insured dies during that time. The second category are investment policies such as whole, universal, and variable life coverage. They provide coverage over the entire life of the insured (also known as permanent life insurance), and accumulate a cash-value over time.

Why would I modify, sell, or cancel my policy?

If you have a term life policy, it may be wise to cancel your policy if it has already served its purpose, that is, if your children are financially independent, you have paid off your mortgage, and have been investing toward retirement for some time. If you cancel coverage, the extra money saved each month (in lieu of premium payments) can be put toward a more profitable investment.

Making changes, or cancelling, permanent life insurance policies require a more complicated analysis because there are a wider variety of options available to the insured. Because permanent life insurance policies accrue a certain rate of return while providing coverage, one must consider the time-value of these policies going forward. The insured individual should compare the net payments required to continue coverage, versus the net surrender cost including the value of the death benefit before cancelling or modifying.

What sort of tax consequences will I face?

To encourage investment, the IRS does not tax money you put into an asset, such as life insurance. The money you put into an asset is called your " cost basis." Understanding your policy's cost basis is important, because it will help you determine how much money you can take out of your policy without owing taxes. The cost basis of a permanent life insurance policy is generally the sum of all your insurance premium payments. The cash value available is the insurance premiums plus your investment gains. In general, if your cash value is higher than your cost basis, the difference in value represents taxable gains.

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Furthermore, the taxation of life insurance proceeds depends on whether you paid your insurance premium with pre or after tax dollars. If you buy life insurance on your own or through your employer, you are likely paying with after-tax dollars and thus will not be subjected to income tax. However, if your company grants an option to purchase life insurance through a vehicle such as a qualified retirement plan, you are making pre-tax contributions which are subject to a tax on the economic value of the difference between the cash value and death benefit each year.

Taxation of the death benefit?

If you die while insured, your heirs receive a death benefit if they are beneficiaries under your life insurance policy. The IRS does not charge income tax on the payout of life insurance death benefits, so your heirs will not owe income tax on this payout. However, if the death benefit is paid in installments rather than a lump sum, the portion of each installment paid from interest gains is generally taxable.

Tax implications of a life settlement

In a life settlement, a third party purchases your permanent life insurance policy and you receive a one-time cash payment. The third party purchaser will continue to pay the premium, but also becomes the policy’s beneficiary. The cost basis of a permanent life insurance policy is the sum of all your insurance premium payments.

In general, the amount the third party pays the insured for the policy, up to the cost basis is tax free, and any additional money up to the cash surrender value (see below) is treated as ordinary income. Any value in excess of the cash surrender value is taxed as a capital gain.

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Tax Implications of a Cash Withdrawal

If have a permanent life insurance policy, there is a cash value that you can take out and spend while you are alive, at the expense of reducing your ultimate death benefit. Whole life insurance provides a guaranteed fixed rate of return, while variable rate insurance reinvests your money into the stock market giving a different return each year.

If you choose to take out some or all of your cash value, the IRS rules say that your cost basis gets taken out of the policy first. This means that these withdrawals are tax free. However, once you have taken out all the money paid as a premium, any money taken out of your investment gains are taxable income.

Tax Implications of Taking out a Loan on your Policy

When you take out a loan and use your life insurance policy as collateral, there is no tax consequence because the IRS does not tax loans. Furthermore, the loan is repaid out of your death benefit, which is also income tax-free. However, the interest you pay on the loan is not tax deductible.

Tax Implications of Cancelling your Policy

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When you cancel (or surrender) your life insurance policy, you get your premium payments back with no tax-consequence because you put money into the policy with after-tax money. The IRS does not want to double-tax you on this amount. However, any investment gains realized upon surrender are subject to income taxes, and are due immediately.

It is important to consider why you got life insurance in the first place, and whether you’ll need it going forward before making the decision to change or cancel your life insurance policy. There might be other ways to raise cash quick, such as borrowing against your 401k, or taking out a home-equity loan. Each option has tax benefits and detriments when compared to the others, but the decision to cancel, sell, or modify your life insurance policy should not be made lightly.

For more information on this topic please contact Califf & Harper, P.C. by calling 309-764-8300 or 1-800-764-4999. This article is intended to provide general information regarding the topic discussed herein but is not intended to constitute individual legal advice.
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