Life insurance can serve multiple purposes besides simply providing your heirs with money if you die. Certain types of policies can provide benefits while you're still alive in the form of tax-free investment growth. However, if you own one of those types of policies and are considering a lump sum withdrawal, several factors must be evaluated, as that distribution can affect your family's future financial well-being.
Permanent Life Insurance
Some life insurance policies last for the owner's lifetime, while others expire after a set number of years. Permanent life insurance products are designed to remain in effect until the covered person dies, ensuring that beneficiaries will receive money regardless of when death occurs. Permanent policies are expensive compared with other types of life insurance, but they provide additional benefits not available elsewhere. The most relevant of these additional benefits is the accumulation of cash value within the policy.
Cash Value Accumulation
Permanent life insurance policies accumulate cash value. A portion of every premium payment made into a permanent policy is set aside in a separate account and is called cash value. Over time, this money may grow based on the interest earned by the investments within the cash value account. A sizable portion of the cash value is necessary for the stability of the policy itself. However, excess cash value may be withdrawn without threatening integrity of the coverage.
Lump Sum Withdrawals
If the cash value within your permanent life insurance policy has grown into a usable sum, and you feel it is necessary and appropriate to withdraw this money, you may do so without immediate penalties or liabilities. However, withdrawing too much cash value may negatively impact your life insurance coverage. Since the cash value actually exists to offset increases in future policy payments, withdrawing too much cash will result in higher premium invoices. Additionally, cash value withdrawals may reduce benefits to your heirs by the same dollar amount.
The taxation of money withdrawn from permanent life insurance policies can be complicated. If your lump-sum withdrawal is less than the aggregate total of all premiums paid, no tax is owed because the IRS considers this a return of those premiums. But, if the withdrawal exceeds aggregate premiums, the excess portion is subject to capital gains tax. You can avoid the capital gains tax, however, if you structure your cash distribution as a loan from the policy because the IRS does not require taxes on loans. It's important to note that if you take a cash value loan and the policy subsequently collapses or is otherwise terminated, capital gains taxes would then be due on the loaned amount in excess of all aggregate premium payments.
Making the Decision
If your life insurance goals or needs have changed, a lump-sum withdrawal from the cash value may not present any dilemma. However, if your intentions remain the same, you must carefully consider the possible negative ramifications to your heirs if you fail to replace the cash or are unable to handle increased premiums. A smaller insurance payout, or no payout at all, could be detrimental to your family's financial stability if you die. Additionally, you must consider the possible income tax liability that might come from a lump-sum withdrawal from life insurance.
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