The Taxation Of Withdrawals From A Life Insurance Policy

If Charlie takes out a $20,000 loan, the loan itself is not taxable, because it is simply a personal loan between Charlie and the insurance company

To further encourage the use of life insurance, Congress has also provided under IRC Section 7702(g) that any growth/gains on the cash value within a life insurance policy are not taxable each year (as long as the policy is a proper life insurance payday loans in Bristol TN policy in the first place). As a result, if a permanent insurance policy is held until death, the taxation of any gains are ultimately avoided altogether; they’re not taxable under IRC Section 7702(g) during life, and neither the cash value growth nor the additional increase in the value of the policy due to death itself are taxable at death under IRC Section 101(a).

One caveat to the favorable treatment for the taxation of life insurance policies is that it applies only as long as the life insurance policy is actually held intact.

If a withdrawal is taken from the policy, the gains may be taxable (as ordinary income), although under IRC Section 72(e)(5)(C), any distributions are treated first as a return of principal (the “investment in the contract”), and gains are only taxable after all the cost basis has been recovered. (Though policies treated as a “Modified Endowment Contract” or MEC are taxed gains-first.)

If the policy is fully surrendered – which means by definition all principal and all gains were withdrawn (at once) – any gains are fully taxable as ordinary income under IRC Section 72(e)(5)(E), to the extent the total proceeds exceed the cost basis.

Notably, when it comes to life insurance, the cost basis – or investment in the contract under the rules of IRC Section 72(e)(6) – is equal to the total premiums paid for the policy, reduced by any prior principal distributions (which could include prior withdrawals, or the previous receive of non-taxable dividends from a participating life insurance policy).

The Taxation Of Receiving A Life Insurance Policy Loan

One of the more popular features of permanent life insurance with a growing cash value is the fact that the policyowner can borrow against the policy without incurring any tax consequences. By contrast, as noted above, surrendering the policy could cause a taxable gain (as would taking withdrawals in excess of the policy’s cost basis, if the policy even allows withdrawals in the first place).

In reality, though, the “tax-favored” treatment of a life insurance policy loan is not actually unique or specific to life insurance. After all, technically a life insurance policy loan is really nothing more than a personal loan from the life insurance company, for which the cash value of the insurance policy is collateral for the loan. The fact that the life insurance company has possession and controls that policy cash value allows the company to be confident that it will be paid back, and as a result commonly offers life insurance policy loans at a rather favorable rate (at least compared to unsecured personal loan alternatives like borrowing from the bank, via a credit card, or through a peer-to-peer loan).

Accordingly, the cash from a life insurance policy loan is not taxable when received, because no loan is taxable when you simply borrow some money! Just as it’s not taxable to receive a credit card cash advance, or a business loan, or the cash from a cash-out refinance, a life insurance policy loan is not taxable because it’s simply the receipt of a personal loan.

Example 1. Charlie has a $500,000 whole life insurance policy with an $80,000 cash value, into which he has paid $65,000 of cumulative premiums over the years. Due to the nature of the whole life policy, Charlie is not permitted to take a withdrawal from the policy (against his $65,000 basis), but he can request a loan from the life insurance company against his $80,000 cash value. The life insurance company will use the $80,000 cash value of the policy as collateral to ensure the loan is repaid.