Gain, in the form of ordinary income, is realized in many surrender, redemption, or maturity situations. Understanding them will help you back a better financial decision regarding your chosen policies. These include:
- Lump sum cash-in – The excess of the amount received by a policyholder in the complete redemption or surrender of a policy) over the policyowner’s investment in the contract (i.e., cost) is taxable as ordinary income. The policyowner determines the amount of lump sum payable and then subtracts from it the cost of the contract. A lump sum generally includes the cash value of paid-up additions, dividend accumulations, termination dividend, and unrepaid policy loans. Any interest previously paid on policy dividends that has already been taxed reduces taxable amount of the lump sum. Generally, cost means net premiums (gross premiums less the total of tax-free dividends received by the policyowner). Any dividends paid by the insurer that were accumulated at interest or used to purchase paid-up additional insurance must be included in the lump sum amount as part of the policyowner’s cost.
- Policy maturity – Older cash value life insurance policies are typically set to mature at age 95 or 100. This means that if the insured is still alive at that age, the policy matures and the cash value is paid to the policy owner in lieu of the death benefit. The amount received would be taxed as discussed above instead of being received as a tax-free death benefit. Due to longer life expectancies, many life insurance carriers have added policy maturity extension riders to their older policies to prevent them from maturing at age 95 or 100 and thus causing adverse tax consequences to the policy owner. Newer products avoid the problem by maturing at much older ages, such as age 120.
- Interest-only option – If the lifetime proceeds are left intact with the insurer to earn interest, that interest is taxable each year as received or credited. The gain on the proceeds is taxable immediately (assuming it can be withdrawn by the policyowner) even if the “interest-only” election is made prior to surrender or maturity.
A policyowner’s investment in the contract is defined as the total premiums (or other consideration) paid less the total amount of nontaxable distributions (i.e., dividends, unrepaid loans, and tax free withdrawals) received.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM