Cash Value
Friday, September 3rd, 2010
How are the whole life insurance cash value withdrawals taxed?
How are whole life insurance cash value withdrawals taxed?
If you live in the United States, there are 2 tax reform acts you should know about:
1) 1984 Tax Reform Act: The act says that the cash value in a contract can build no faster than to equal to the face value when the insured reaches age 95. If any policy builds cash value more rapidly than this benchmark, it loses most or all of its tax advantages such as tax deferred growth and no income tax on death benefit.
2) 1988 Tax Reform Act: This law says that if a policy creates a cash value faster than that of 7-pay Whole Life Policy (meaning in 7 years, the cash value should not be worth more than what it is suppose to be), then the policy is a Modified Endowment Contract. Whether its Whole Life, Universal Life, or Variable Life, if the cash value grows faster than a 7-Pay Whole Life policy, then any loan or withdrawal must be made with the understanding that taxable dollars comes out first, then the return premium (which are made with after-tax dollars) dollars. Furthermore, there is a 10% penalty in addition to any taxes due on all withdrawals prior to age 59 1/2.
Anyway, I have never seen a whole life policy where cash value is more than total premiums paid, so its very likely that you are not affected by this rule. I have also never seen a whole life policy where you can take withdrawals of the cash value. You can borrow it and pay interest of around 8%. When you pay it back, the interest goes to the insurance company, not to the cash value.
If you decide to cancel the policy someday while there's a loan balance due, you will be responsible for income tax on the remaining balance. Before I replace any cash value life insurance policies with term insurance or do a 1035 exchange into a variable annuity, I always make sure that the client pays it back to avoid taxes.
If you die someday while there's a loan balance due, this amount plus interest plus any missed premiums will be deducted from the face amount of the policy. No income tax will be owed if this happens, unless the policy is a modified endowment.
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