Many individuals by a whole life term policy with a defined death benefit and do not realize the tax liability them may incur by cashing out or taking the surrender value of the Life Insurance Policy. These types of life insurance policies have a stated benefit amount (for example a $100,000) and fixed annual premiums (for example $1,800).
Since there is a defined amount that is to be paid out, insurance companies will charge premiums to create what is called an overage during the early years of the policy. During that period you will build up a balance from your insurance payments that is called the Cash Value of the policy. As you get older the risk of death becomes higher and the likelihood of paying out becomes more likely. The overage will generally tend to decrease during this period, but your premiums will stay constant at $1800 per year.
The “Cash Value” of your life insurance policy can be used to make additional premium payments, taken out as cash, as collateral for a loan from the Insurer or to purchase additional insurance. If you cancel your policy you will receive the Cash Value minus any monies owed to the Insurer. However, the Insurance Company will invest the annual premiums you pay and provide part of the investment income in the form of a dividend to the Insured. These dividends can be used to purchase additional insurance, pay off monies owed to the Insurer, pay premiums or taken out as cash by the Insured.
However, if your monies owed to the Insurance Company become greater than the Cash Value, then the Insurance Company may cancel your policy. In these cases, often times you will also incur a tax liability if the net investment costs are less than the Cash Value at the time of cancellation. For example, if you paid $44,000 in premiums over the life of the policy, but received $35,000 in additional insurance and dividends, your net investment cost will be approximately $9,000.
If, at the time of cancellation your Cash Value is greater than $9000, then you will have additional taxable income to report the year that your policy was cancelled. For example, if your Cash Value was $37,000 but you owed $37,030 to the Insurance Company. The Insurance Company can cancel the policy and keep the $37,000 as a set-off against the monies you owe. However, you will have to report $37,000 minus $9000 as your taxable income for that year to the IRS or Uncle Sam. Since this was a personal loan provided by the Insurer to you, you cannot deduct the amount paid to the Insurer in reporting your taxable income.
The irony is that although you will not receive any cash or proceeds you will end up having to report an additional $28,000 for your taxable income for that year. This form of unanticipated tax liability can make it difficult to plan for your personal financial goals or your personal activities and budget. A better method of using and purchasing these types of life insurance policies is to purchase the policy through your business. In these types of cases, at least you will be able to deduct any loans that you took out on the policy from your businesses income for tax reporting purposes.
Life Insurance is a great tool for protecting your loved ones in the event of your death; however, you want to make sure it does not create an unanticipated tax liability for you during your life. If you have concerns or questions on how to structure these types of arrangements properly, then please feel free to contact us.