The value of a life insurance policy can impact a number of situations. For example, the possibility of a taxable gain if the policy is surrendered, which is often omitted in sales presentations.
The inside interest is typically income tax deferred, which is either income-tax exempt or partially income tax exempt – depending upon how the policy terminates and the circumstance surrounding termination.
There are four possibilities:
The policy terminates upon the insured’s death. The death benefit is generally received income tax free by the beneficiary, so the inside interest is income-tax exempt.
The policy is surrendered and the sum of the cash value and the total dividends are smaller than the total premiums; that is, there is a “loss” on surrender. Generally, the cash value is received income tax free by the policyholder, so the inside interest is income-tax exempt.
The “loss” is not deductible, because the price of the protection exceeds the inside interest, and the price of the protection is not deductible – except to the extent it offsets what otherwise would be taxable as inside interest.
The policy is surrendered and the sum of the cash value and total dividends is equal to the total premiums; that is, there is no “gain” or “loss” on surrender. Generally, the cash value is received is received income tax free by the policyholder, so the inside interest is income-tax exempt.
In this instance, the price of protection and the inside interest is equal, so that the nondeductible price of the protection offsets the taxable inside interest.
The policy is surrendered and the sum of the cash value and the total dividends is larger than the total premiums; that is, there is a “gain” on surrender. Generally, the “gain” is ordinary income to the policyholder in the year the policy is surrendered, so that the inside interest is partially taxable.
The inside interest – which in this instance exceeds the price of the protection – is income-tax exempt to the extent of the price of the protection and taxable to the extent the inside interest exceeds the price of protection.
Please note that this does not constitute tax advice and that we are not tax advisers. Please consult your tax adviser as rates and exemptions are subject to change.
(Source: The Insurance Forum; November 2001 issue, article excerpt; Dr. Joseph Belth.)
By Tony Steuer, CLU, LA, CPFFE
Tony Steuer is an author and advocate for financial preparedness. Tony Steuer, CLU, LA, CPFFE, helps people make sense of the financial world in a way that’s easy for them to understand. His books including, “GET READY!,” “Insurance Made Easy,” and “Questions and Answers on Life Insurance,” have won numerous awards. Tony is the founder of the GET READY! Initiative which includes the GET READY! financial organization system, the GET READY! Financial Preparedness Club, GET READY! Podcast, and the GET READY! Financial Principles, a best practices playbook for the financial services industry. Tony served as long-term member of the California Department of Insurance Curriculum Board. Tony is regularly featured in the media including the New York Times, the Washington Post, Fast Company, and other media. He has also appeared as a guest on television shows, such as ABC’s “Seven on Your Side.” Visit https://tonysteuer.com/ to join the GET READY! Financial Preparedness Club and access free resources.