Taxation of Life Insurance Policy Withdrawals

A withdrawal is the partial surrender of a policy. 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 reserves of a flexible premium (i.e., universal or adjustable life) policy exceed the policyowner’s cost (accumulated premiums). Until the policyowner has recovered his aggregate premium cost, he will generally be allowed to receive withdrawals tax free under what is known as the cost-recovery first rule.

But, this income tax liability is accelerated if a cash distribution occurs within fifteen years of the policy’s issue and that distribution 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. Loans are not treated as distributions and do not reduce policy death benefits.

A notable exception to the cost-recovery rule applies to life insurance contracts classified as Modified Endowment Contracts. Generally, distributions from MECs are taxed under the interest-first rule which provides that the first distributions out of the contract are deemed to be taxable interest.

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

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