Choosing life insurance coverage is often compared to putting a roof over your head. In that analogy, term insurance is like a rental home, while a permanent life policy is likened to owning your own house. The latter can be more costly, but it will build equity over the long term. If you decide at some point to surrender the policy and cash out its equity, you might face some tax implications.
Life Insurance and Taxes
In a permanent life insurance policy, your money can grow without taxation, making such a policy attractive if other tax-sheltered investments -- such as an IRA or a 401(k) -- are already maximized. A traditional whole-life policy won't generate significant cash value until it's been in force for 15 to 20 years, but that policy Grandma bought when you were born might be a little gold mine. Otherwise, you can grow your funds more quickly in an aggressively invested universal life policy. If you later decide to surrender your policy, the gain can trigger a tax liability.
Gains vs. ROP
With a permanent life insurance policy, the insurer will send you a statement at least once a year showing the total of your premiums and how much growth you've had in your policy. If you're thinking about cashing in the policy, that's important information. Your premiums were paid in after-tax dollars, so everything up to that total is considered return of premium, or ROP. However, all remaining funds in the policy over that amount are fully taxable in the year your policy is surrendered. Worse, they're treated as ordinary income for taxation purposes rather than lower-tax capital gains.
Aside from taxation, you might face additional penalties for surrendering your policy. Permanent life insurance is a costly product for the insurer, with underwriting and administration costs as well as a hefty commission to the broker. The company mostly pays those costs up front, so you can expect to pay some fees if you surrender your policy before the insurer has recouped its expenses. Fees will vary by company and policy, so read your policy carefully. Surrender charges are highest in the early years of a policy, while taxation becomes an issue in later years. That means one or the other might cost you, but seldom both.
Choosing to Surrender
Surrendering your policy might seem like a relatively quick and simple way to obtain a lump sum in a time of need. However, between the taxation and surrender charges, you'll often pay a hefty premium. Don't pull the trigger on your policy until you've looked at alternatives. For example, with most policies you can withdraw the entire amount of your premiums as a loan without creating a tax liability. If you do opt to go ahead with the surrender, your insurer will send out the appropriate forms. You'll need to sign them and -- possibly -- have them witnessed. However, most companies issue the check within a week or two of receiving the forms.
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