Cash-value life insurance, such as whole life and universal life, build reserves through excess premiums plus earnings. These deposits are held in a cash-accumulation account within the policy. However, when a cash value policy is cancelled (surrendered), some of the proceeds that you receive may be taxable.
Some of the tax consequences that you want to consider are:
- Cash-value withdrawals are not always received income-tax free. For example, if you take a withdrawal during in the first 15 years of the policy and the withdrawal causes a reduction in the policy’s death benefit, some or all of the withdrawn cash could be subject to taxation.
- Withdrawals are treated as taxable to the extent that they exceed your basis in the policy. Ones basis is the total premiums paid for the policy less any refunded premiums, rebates, dividends or underpaid loans that were not included in income. Thus, if you are thinking of cashing it out you will want to know how much you invested in terms of premiums over the course of the policy.
- If your policy has been classified as an Modified Endowment Contract (MEC), withdrawals generally are taxed according to the rules applicable to annuities – cash disbursements are considered to be made from interest first and are subject to income tax and possibly the 10% early-withdrawal penalty if you’re under age 59 1/2 at the time of the withdrawal.
If you’re looking for the IRS guidance on how to determine how much is taxable, we suggest looking at at the “Life Insurance” section of Publication 525 or taking a look at Rev. Rul 2009-13.