If I surrender this life insurance policy and take the $40,000, are there any tax consequences?
I have a flex life policy for $100,000 that has a cash value or surrender value of $40,000.
Here are a few things you to think about:
Anything above your cost basis – the total premiums paid – would be taxable as ordinary income. Call the carrier and ask them to calculate the cost basis for you. It's an easy task.
Do you need a survivor benefit? Consider your need for life insurance going forward. You might not qualify for a good price further on down the road, if unfortunately your health changes. So maybe you want to hold on to the coverage.
I'm going to guess that the policy has been around for a while, and that you have been over-funding it. A cash surrender value of $40,000 is pretty good for $100,000 policy. Ask the carrier what is the minimum monthly payment you would need to sustain the coverage. You could take out a loan for the difference.
It depends. You will need to contact the insurance company to determine what your cost basis is. Once you have that number, here is how it would work:
$40,000 of cash value
If the cost basis is $40,000 or less, no taxes will be due.
If the cost basis is $40,001 or higher, than the amount of the basis will be taxable as ordinary income.
If you would like to defer the tax and want to keep it invested, you could consider 1035 exchanging into a non-qualified annuity. This would defer the tax until a later date. If you choose this option, the funds are unavailable without an IRS penalty until age 59.5.
Proceeds from the death of the insured are tax-exempt. However, if you cash in a policy early, you MAY create taxable income.
A cash value life insurance policy is similar to a savings account. You deposit money into the life insurance policy in the form of premiums, the insurer uses a portion of your deposits to pay for the life insurance benefit and the remainder is invested. If you pay for enough years, your policy builds up a cash surrender value, or CSV. If the CSV is more than the premiums (that is your tax basis or cost basis in the policy) and you surrender the policy (cancel it), the excess is earnings and taxable income. For example, if you paid $1,500 in policy premiums for 20 years (total premiums of $30,000 and you cash in the policy and receive $40,000, you’ll pay ordinary income tax on $10,000 in earnings.
You should receive a Form 1099-R showing the total proceeds and the taxable part. Report these amounts on lines 16a and 16b of Form 1040.
One way to avoid taxes is to look into getting a policy loan. You will not get the full cash surrender value, but a policy loan is generally NOT taxable if the policy stays in force for your lifetime (you die with insurance in force). Thus, prior to taking a policy loan, you should contact your insurance agent to look at projections to see how much you could or should take. A loan is not taxable if when purchased, it was a Modified Endowment Contract (or a MEC) - that usually happens if you front end load a policy with a large cash deposit.
In certain cases, accelerated death benefits are not taxable income if the insured is terminally or chronically ill. This is generally referred to as a viatical settlement. This differs from a surrender of the policy to the insurer. If you’re contemplating a surrender of the policy because of need resulting from a terminal illness, you may be better off with a viatical settlement.
This boils down to you "cost basis" - How much have you paid into this Flex Life Insurance Policy? If you have paid more than $40,000 into the policy the withdrawal would be tax free, but if you have made a profit on the policy over the year you may owe taxes. If you do sell, surrender, or withdraw from the policy, the difference between what you get back and what you paid in is taxed as ordinary income.
If you are concerned about taxes talk with a Fee-Only Fiduciary Certified Financial Planner may be able to help restructure the policy to maximize the cash value and minimize the death benefit. Also help come up with a strategy to minimize or eliminate taxes on your withdrawals.
A bit more info on how to maximize the value of your insurance:
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DAVID RAE, CFP®, AIF® is a retirement planning specialist with DRM Wealth Management. He has been helping people reach their financial goals for over a decade. He is a regular contributor to the Advocate Magazine as well as Huffington Post, and is an on demand guest on TV and Radio. For more information visit his website at www.davidraefp.com or the Fiduciary Financial Planner LA Blog
This all depends on what your basis is in the life policy, how much have you paid into the policy. For example, if you have paid over $40,000 in premiums into the policy than there would be no taxable event.
However, let's say that you only paid in $20,000 into this policy over the years. You would be responsible in this instance to pay ordinary income tax on the $20,000 gain ($40,000 you receive for surrendering the policy minus the $20,000 you had paid in).
It is best to consult with your tax advisor to see how you will be affected by surrendering the policy. Your insurance company should be able to provide you with the amount you have paid in or the basis in the policy.