Whole life insurance accumulates cash value on a tax-deferred basis. As the owner, you have full rights to the money in the policy but can only get at it through a loan or by surrendering it. Taking a loan allows you to keep the policy in force, but you’ll have to repay the money with interest. You might have to pay taxes when you close out the policy -- either by surrendering it, not paying the premiums or loan payment. Under certain circumstances, you can reinstate your policy. How your policy closes determines the tax implications.
Reinstating your life insurance policy typically won’t avoid taxation. Surrendering the policy for cash value is generally the only taxable non-forfeiture option, and you can’t reinstate your policy if you surrender it for the cash value. The other options are to use the cash value for another life insurance or annuity contract. Those exchanges occur without recognizing any gain or loss because of a provision in the tax code.
When you apply for a life insurance contract that accumulates cash value, you have to specify a non-forfeiture option. The cash value belongs to you even if you break the terms of the contract, and the insurance company must pay it out to you. Companies often comply with that requirement by offering several options for how you take the money. You could have the company send you a single check, use the money to purchase a smaller paid-up insurance policy, use the money to pay the premiums on a term life insurance policy with the same death benefit or transfer the money into an annuity.
Your right to reinstate a life insurance policy depends on the provision in the contract and state law. Typically, you have up to three years to meet the insurance company’s requirements for reinstatement. Paying past-due premiums plus interest, repaying outstanding loans on the policy and proving your health hasn’t changed significantly since the original application are common requirements. Once you meet those requirements, the insurance company places your policy back in force as if it had never lapsed.
Life Insurance Taxation
You don’t have to recognize any amount credited to your cash value in a life insurance policy as income until you take it out. Even then, you only report income to the extent that you pulled more money out than you paid in. Depending on the terms of your contract, you might receive dividends or have the right to take loans against the cash value. Dividends reduce the amount of money you paid in -- that's why you get them tax-free -- and loans increase the amount of money you pulled out. The U.S tax code allows you to exchange a life insurance policy for another life insurance policy, an annuity or a qualified long-term care insurance contract without recognizing any gain. Such exchanges are called 1035 exchanges and work similarly to a direct rollover between retirement plans.
Sean Butner has been writing news articles, blog entries and feature pieces since 2005. His articles have appeared on the cover of "The Richland Sandstorm" and "The Palimpsest Files." He is completing graduate coursework in accounting through Texas A&M University-Commerce. He currently advises families on their insurance and financial planning needs.