Tax on Withdrawal From Life Insurance

Life insurance withdrawals can be taxable in certain situations

Source: StockMonkeys (Flickr)

Permanent life insurance policies offer an additional benefit beyond providing heirs with money if you die. Equity typically accumulates in these products and can be withdrawn by the policy owner.

However, care must be taken when considering a distribution from life insurance cash values to avoid income tax liability and damage to the integrity of the policy.

Permanent Life Insurance

Permanent life insurance is a type of policy designed to last your entire life. Most insurance companies structure premiums for this type of policy to ensure coverage until you are at least 95 or 100 years old.

Permanent life insurance policies build equity over time, as opposed to term life insurance products, which have no equitable value unless you die.

Cash Value Accumulation

Permanent policies accumulate cash value because a portion of your premium payment is set aside into a separate account within the policy. That account earns a rate of return depending on the type of permanent life insurance product you own.

Cash value grows without income tax liability as long as the money remains in the insurance policy. You may withdraw cash value in the form of a loan, but siphoning too much may threaten the stability of the policy.

Borrowing From Permanent Policies

If sufficient cash value has accumulated within your permanent life insurance policy, you may borrow that money. Your distribution is structured as a loan to avoid income tax liability.

The IRS does not tax life insurance policy proceeds or cash value loans. Once a loan is disbursed, a schedule is created to facilitate repayment along with nominal interest charges.

Surrendering a Permanent Policy

If you cancel life insurance coverage and receive a distribution from the remaining cash value, you may owe income tax on that money. The portion of the refund that is larger than the total premiums you paid is fully taxable as interest earnings.

The insurance company will issue a 1099 tax form stating the gross amount of the distribution, but it is your responsibility to calculate what portion is a return of premium and what portion is excess.

Article originally published on Zacks.com (10/16/2012)