Understanding Withdrawals on Variable Life Insurance Policies

An important exception to the general cost-recovery rule applies for withdrawals within the first fifteen years after the policy issue date that are coupled with reductions in death benefits. Because insurers generally reduce death benefits in an amount equal to any withdrawal of cash values, policyowner withdrawals frequently may trigger a tax on all or part of these withdrawals to the extent of gain in the policy.

The rules tax such withdrawals in whole or in part as ordinary income to the extent that they are forced out of the policy as a result of the reduction in the death benefits. The taxable amount depends on when the owner makes the withdrawal:

  • Within first five years ­– If the withdrawal takes place within the first five years after policy issue, a very stringent and complex set of tests applies. Potentially, a larger portion, or perhaps all, of any withdrawal within the first five years will be taxable if there is gain in the policy.
  • Fifth to fifteenth years – For withdrawals between the end of the fifth year and the end of the fifteenth year from the issue date, a mathematical test applies. Essentially, the rules tax the policyowner on an income-first basis to the extent the cash value before the withdrawal exceeds the maximum allowable cash value under the cash value corridor test for the reduced death benefit after the withdrawal. Frequently, in these cases only a portion or even no part of the withdrawal will be taxable.

Changing from option B (increasing death benefit) or from option C (return of premium) to option A (level death benefit) will trigger a test to see whether any amount must be forced out of the policy. In general, option B and option C contracts allow for greater cash accumulations within the policy than option A contracts. Consequently, if a policy with option B or option C has close to the maximum permitted cash value under that option, a switch to option A generally will trigger a taxable distribution. 

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

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