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Cashing Out Whole Life Insurance Policy
You have a whole-life policy and you want to know the consequences (tax) of cashing it out.
I am not considering selling the policy or withdrawing from cash value so I'm not covering that here; and I have enough other insurance etc so I don't need the policy any longer.
I'm looking to reinvest the proceeds of cashing in the policy.
Essentially, you can withdraw the amount of money equivalent to the amount you’ve paid in premiums tax-free. However, if the cash value—the amount you receive either via withdrawal or surrender—is higher than what you’ve paid in premiums, you may need to pay income taxes. Those taxes would only apply to the amount over what you’ve paid in premiums.
Remember that you will have to pay taxes on the income that is above the premiums you have paid over the years for this plan. You might not have to pay taxes, though, if you are in the early stages of a life insurance plan. Speak to a trusted financial advisor who can take you step-by-step through the process. You might not have very much to pay in taxes and this could be directly to your advantage.
Tax consequences of cashing in life insurance: If you cash in a whole life insurance policy, you will have to worry about the tax consequences that are involved. When you put money into a whole life insurance policy, it is allowed to grow on a tax-deferred basis. This means that if you take out all of your money, you will have to pay taxes on the amount that you gained.
You surrender the life insurance policy
There can be times when a policyowner no longer wants or needs the life insurance policy. You can take the surrender value of the life insurance policy and the insurer will terminate the coverage. The amount you receive is your cash value minus any surrender charge. You can generally expect to get a surrender charge within the first 10 or 20 years of owning the policy, and over time the surrender charge phases out.
You won’t be taxed on the entire surrender value, though. You’ll be taxed on the amount you received minus the policy basis, or the total premium payment you made on the policy. This taxable amount reflects the investment gains that you took out.
Say the premiums you’ve paid over many years add up to $38,000 and your total cash value is $45,000. The portion of the payout that would be taxed is $7,000, representing the investment gains.
If and when a policyholder elects to take the cash value of their whole life insurance policy, the amount they are required to pay taxes on is the difference between the cash value they receive and the total they paid in premiums during the time the policy was in force.5 If, for example, they pay $100 per month for 20 years, or $24,000, and then cash out the policy and receive $30,000, the amount subject to taxes is $6,000.
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. Determining Total Tax Obligations
Now that you assessed the total amount of profit you will earn from the cash-out, you can accurately assess the specific amount of tax you will be required to pay. The funds you receive from the cash surrender value are taxable as ordinary income rather than capital gains. This means that these funds will be subjected to federal income tax regulations as well as any state-level income tax policies.
When it comes time to report this income on your tax return, you will use the standard IRS Form 1040 and list the profit from your policy as “other income.” Keep in mind that this profit must be reported on Form 1040 during tax filing. Failure to do so can result in a variety of penalties and fines from the IRS.
Once you have committed to your cash out, your life insurance provider will provide you with a 1099-R that lists the gross payout from your policy following the cash-out. This information can act as an official point of reference once you begin filing your tax documentation.