What is the tax ramification if I surrender life insurance?

Submitted by Ev on Tue, 12/06/2011 - 06:10

I have a 20 year old whole life policy for 100k which I stopped paying premiums on 3 years ago and instead have the dividends pay the annual payments. I also have 1.1 million in two term life policies. I want to surrender the whole life for it's cash value which is around $30k so I can invest it. I really dont think I need it anymore. My cost basis is around $25k and I was wondering at what rate will I be taxed. Personal income or capital gains rate?

Posted: 07 Dec 2011 12:31 Post Subject:

Taxes would be based on plain, old ordinary income rates. Just add the amount to your W-2 taxable wages. Gee, how much fun!

InsTeacher 8)

Posted: 12 Dec 2011 12:21 Post Subject:

Our friend TaxFreeIncome would tell the poster just to take all the "Tax-Free Income" from the policy and be happy. Then he'd have to explain to the poster why he had no money left to pay that tax bill after the policy actually lapsed.

Posted: 26 Aug 2012 06:14 Post Subject: withdrawing total premiums paid in

I read that you can actually withdraw the amount of total premiums paid into a policy without it being taxable. Is this true?

Posted: 26 Aug 2012 08:18 Post Subject:

If you have a "cost basis" in a life insurance contract, you may generally withdraw up to that amount without an income tax liability.

One needs to remember that policy loans and capitalized loan interest generally reduces the available cost basis. So the person who, let's say, pays $20,000 in premiums, then doesn't pay the next $7500 in premiums, and then borrows $20,000 from the policy, has now exceeded the actual available cost basis in the contract.

There is not a current tax problem as long as the policy does not lapse -- which generally means not failing to pay premiums and, at a minimum, any policy loan interest from year to year.

Borrowing up to, but not more than, the cost basis in a whole life policy is less risky than doing the same from a Universal Life policy of any type -- UL, IUL/EIUL, VUL. Attempting to do this with a UL policy (which is being heavily promoted with IUL) is far more hazardous, due to the annual renewable term life (ART) premiums in the policy. Borrowing from cash value alters the Net Amount at Risk (NAR) equation, and raises the amount of capital that must be fed into the policy -- either in the form of interest credits (usually negated by the loan interest) or cash.

Failure to fund the policy to overcome the increasing NAR and ever-increasing cost of insurance, accelerates the point in time when the UL policy will lapse due to insufficient cast accumulation.

When the policy lapses, all value is gone, which means that more than the cost basis in this scenario has been paid out of the policy. All excess over basis, including interest credits that were consumed to pay other policy expenses, creates a current income tax liability in the year of lapse.

Where will the money come from to pay the income tax due? Failure to pay those taxes in a timely manner means the imposition of penalties and interest. Where will that money come from? "I'll hire one of those tax-dispute companies to fight for me." Where will the money for that come from?

Life insurance is designed to be funded, not borrowed from. That the Internal Revenue Code currently allows for borrowing from the death benefit -- which is normally paid to the beneficiary tax-free -- as a tax-free advance, well, if a person wants to do that, they may. Should a person do that? Only as a last resort.

We're heading toward trial on a life insurance case in South Carolina because a life insurance policy for a disabled person lapsed not long before his death. According to the insurance company, he failed to pay a $55 loan interest payment, causing his policy to lapse.

Does it sound reasonable that a person who knew his death was fast approaching would let his life insurance lapse -- especially when he was not required to pay premiums -- all for want of a $55 payment?

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