People need to be aware of the rules that govern taxes on life insurance cash withdrawals. Death benefit payouts are exempt from income tax, but what about life insurance dividends, surrenders, or cash value withdrawals or loans?
There are three basic permanent insurance products that generate cash value reserves upon and they are Whole Life, Universal Life and Endowment Contracts. Whole life insurance policies offer the possibility of dividends, while univeral life and endowment contracts do not.
Whole Life Insurance Cash Values
Whole life products accumulate cash value and are designed to mature at the insured’s end-of-life, or 100 to 121 years. When a policy matures, it simply means that the premiums paid in equal the amount of death benefit.
The cash value in a whole life plan, therefore, is adjusted to equal the death benefit upon maturity. Furthermore, cash value withdrawals are capped at an amount that is less than premiums paid in, to-date. The withdrawals are tax free because the cash value in the policy is pre-taxed money already.
Money you withdraw from the cash value in your policy can be in the form of loans or straight withdrawal. The money received is not taxed because the cash value reserve is presumed to be consisting of pre-taxed money from your premiums paid in.
If your whole life insurance plan has the enhanced feature of providing dividends, any dividends received is viewed by the IRS as taxable additional income and will need to be reported to the IRS at tax time.
Policy dividends in whole life insurance policies can be guaranteed or unguaranteed. Since dividends are simply a share in the profits an insurer realizes from money market investments, the amount fluctuates based on revenue. Some years will yield less dividends than other years, or possibly no dividends if the reported revenues of the insurer dictates.
Guaranteed dividend whole life insurance policies typically are designed with padded premiums in which an insurer can recoup any revenue losses on the years interest revenue on investments is less than the guaranteed dividends the company is obligated to pay out to policyowners.
A dividend is defined as a revenue sharing by the insurer of funds received from investments from the insurer’s premium in-take reserves. It is a perk the insurer may or may not extend to its policyowners or limited to certain product plans. Just remember that a dividend is always reported as additional income when you file your annual taxes , according to the Internal Revenue Service.
Universal Life Insurance Cash Values
Universal life: Accumulate cash value and designed to mature at insured’s end-of-life, 95 to 121 years. Cash value and death benefit are separate reserves within the policy and cash received from these plans may be subject to income tax.
Endowment Contracts’ Cash Values
Endowment Contracts: Product that generates cash value reserve; policy designed to mature in terms of usually 10 to 20 years
In permanent life insurance, in general, the tax rules vary in the ways funds are taken and the amounts that are pulled from them. If cash value in a policy is withdrawn prior to the policy’s maturity date, the funds received are tax free if the sum is less than the death benefit and passes the “seven-year-test.”
Free from taxes
Funds that are received after a policy matures are typically tax free. When a policy matures it means its cash value now equals the death benefit.
Endowment life insurance contracts are life insurance products that are designed to return cash value as a lump sum withdrawal, loan or dividend payment. The tax rules on each type of these withdrawal types is different.
If you withdraw the cash value in a whole life insurance policy and the amount does not exceed the amount of premium paid in on the policy, the money received in tax free.
Another life insurance product in which money can be withdrawn is universal life insurance policies. Since these policies allow cash out advances to policyholders in excess of premiums paid in to the policy, a seven-year-test must be passed in order for the withdrawed funds to remain tax free.
Under the current rules, policies must pass this “seven-year test,” which imposes a cumulative cap on the amount of money that can be held in reserve in the policy. If the amount in the policy reserve exceeds this capped limit, they receive a new classification of modified endowment contracts (MECs). Any withdrawal taken from these newly classified MEC policies in excess of the seven to be withdrawn exceeds this capped limit, the contract is
If a policy doesn’t pass the seven-pay test, they receive a new classification of modified endowment contracts or MECs. This means that loans or withdrawals from an MEC are taxed on a “last-in-first-out” basis.
For example, a policyholder under the age of 59.5 would have to pay a 10 percent penalty for early withdrawal and be subject to guidelines set by the Internal Revenue Service.
on those investments are subject to being taxed as income. You would report this type of additional income on a form you are receiving dividends on the interest earned in a cash reserve life insurance policy, such as a whole life plan. That does need to be reported on your taxes as additional income for that calendar year
Another type transaction in which cash is received from a life insurance policy is to “cash out” on the cash value in a whole life policy. As long as the cash you receive back is less than the amount of your premiums paid in, you can collect the funds and not have to report them as taxable income.
Another type of transaction you receive funds from a life insurance policy are under endowment policies. Endowment policies are life insurance plans under which the policyowner receives a lump sum after the maturity date. Money received includes premiums paid in and any interest earned from the investments of the policy’s reserve.