Your whole life or variable life insurance policy could be a source of cash while you’re still alive. Each policy has a cash-surrender value that grows as you continue to pay premiums. If you decide to cash out your life insurance, you will owe taxes on the cash you receive. Knowing the tax penalty before you cash out will help you decide whether to take the cash now or later, and avoid expensive tax penalties.
Add up all the premiums you’ve paid for the policy over the years. Subtract any dividends you've received or previous cash amounts you've withdrawn from the policy. The resulting number is your basis, or your investment in the policy. If you paid $5,000 in premiums and received dividends of $500 and took out no cash, your basis is $4,500. Agency commissions and administrative fees are not part of your basis. If the premiums you paid included these fees, subtract these amounts from your basis.
Subtract your basis from the cash-surrender value of the policy, or how much you expect to receive in cash from the policy. This difference is your profit. For example, if the cash value of your policy is $14,500 and your basis is $4,500, your gain is $10,000. You must pay taxes on any profit. If you've paid in more money in premiums than the policy is worth now, you'll have a loss. You'll still receive a payment equal to the policy's value now but the amount won't be taxable. For example, if your policy has a value of only $3,500 and your basis is $4,500, you'll receive a check for the $3,500, but you will owe no taxes on this amount. Because the proceeds from life insurance are treated as ordinary income, and not a capital gain or loss, you cannot use this loss to offset other gains.
Report this profit on your federal income tax return as ordinary income. Write in the amount of the gain on Line 21 of Form 1040, "Other Income." To determine the effect cashing in the policy will have on the tax you pay before you actually cash in the policy, multiply the gain you will realize by the percentage you pay in taxes. For instance, if you expect to realize a gain of $10,000 from cashing in your life insurance and you are in the 25 percent tax bracket, you will pay an additional $2,500 in taxes if you cash in the policy.
- When you cash in a life insurance policy, the insurer will issue you a 1099-R, which shows the gross payout you received from the policy.
- Bankrate.com: Is Cash Surrender Value of Insurance Taxed?
- Bankrate.com: Cashing Out of Life Insurance
- The Madison Group: Taxation at Maturity – Cash Value Life Insurance
- Ameriprize Financial: Tax Planning Tips -- Life Insurance
- IRS: Internal Revenue Bulletin 2009-21: Amount of Income Recognized Upon Surrender of the Life Insurance Contract