Taxation of Life Insurance Policy Withdrawals

Distributions from a cash value life insurance policy can either be a withdrawal or a policy loan. A withdrawal is the partial surrender of a policy (i.e., it reduces both the cash value and the death benefit). As long as the policy is not classified as Modified Endowment Contract (MEC) which is covered in more detail in Chapter 22, distributions from the policy on taxed on a LIFO (last in, last out) method, meaning that basis comes out first. Therefore, a policyowner will not have taxable income until withdrawals (including previous withdrawals and other tax-free distributions from the policy such as dividends) made from the cash value exceed the policyowner’s basis in the policy (i.e., cost-accumulated premiums paid). Once withdrawals exceed basis, then gain in the policy is considered to be withdrawn and it will be taxed as ordinary income.

However, this income tax liability is accelerated if a withdrawal occurs within fifteen years of the policy’s issue and that withdrawal is coupled with a reduction in the policy’s contractual death benefits. A withdrawal within fifteen years of policy issuance coupled with a drop in death benefits triggers income. Subject to a statutory ceiling, all the income growth in the cash surrender value is deemed to have been received by the policyowner.Once the fifteen-year period expires, no immediate taxation will occur upon a withdrawal. This fifteen-year rule does not apply to policies issued prior to 1985, or to policy loans.

Although policy withdrawals in excess of basis are taxable to the extent of gain in the policy, it is possible to continue to take tax-free income from a cash value life insurance policy even after all the basis has been withdrawn. This is accomplished by only taking withdrawals up to basis, and thereafter taking any further distributions in the form of policy loans. An alternative way to enjoy tax-free distributions from a cash value policy is to take only policy loans. Policy loans will not cause the gain in the policy to be taxable, with the notable exception if the policy is a MEC. If a policy is a MEC, then any distributions from the policy (either withdrawals or loans) are taxed under the FIFO (first in, first out) method, which provides that the first distributions out of the contract are deemed to be taxable gain.

The ability to take tax-free distributions from a non-MEC policy, combined with the benefit that the cash value grows tax-deferred, has led to considerable use of cash value life insurance as a supplemental retirement vehicle for those who do not have access to a qualified retirement plan or who desire to save more for retirement than what they are permitted to contribute to the qualified retirement plan or individual retirement account (IRA). The strategy of using cash value life insurance as a supplemental retirement tool is sometimes referred to as a Life Insurance Retirement Strategy (LIRP).

Reproduced with permission.  Copyright The National Underwriter Co. Division of ALM

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