When you bought your permanent life policy, you may have thought you’d hold it until you died. If circumstances change and you need cash more than you need a life insurance policy, you can cash in the permanent life policy for the value from the premiums you paid and the interest and dividends you earned on the investments the insurance company made with your money. If you cash in your policy, the premiums you paid are not taxable, but the interest and dividends you earned are.
Whole or Universal Life
A permanent life insurance policy -- typically sold as whole life or universal life --covers you from the time you purchase it until your death, unless you cancel it or allow it to lapse. These policies operate somewhat like savings accounts. When you pay your premium, you deposit money that your insurance company uses to pay for your life insurance benefit, investing the rest. In this way you build up a cash value -- or a surrender value if you cash it out within the first few years.
Most permanent life policies allow policyholders to cash in the account. Your withdrawals will be tax free up to the basis you have in the policy; the amount of premiums you paid into your policy minus any previous withdrawals or dividends give you your basis. Because you used after-tax dollars to pay your premium, the Internal Revenue Service won’t tax you again on those dollars when you cash in your policy.
The IRS requires you to pay taxes on the interest and dividends earned on your life insurance policy. These earnings built up without being taxed while in the policy, so you must pay taxes when you take distribution via a withdrawal or cashing in of your policy. Your life insurance provider will send you Form 1099-R by Jan. 31 of the year after you cashed in your policy. Form 1099-R shows the taxable amount of your cash value; this taxable amount is what you include on your income tax return.
Example of Taxable Proceeds
Say you pay $2,000 annually in premiums on your life insurance policy for 10 years and never received any dividend checks or withdrew any money. You now have a basis in your policy of $20,000. You surrender -- or cancel -- your policy, now worth $32,000, for its cash value. You will receive a Form 1099-R showing $12,000 in taxable income. The remaining $20,000 is simply a return of the money you invested.
Tiffany C. Wright has been writing since 2007. She is a business owner, interim CEO and author of "Solving the Capital Equation: Financing Solutions for Small Businesses." Wright has helped companies obtain more than $31 million in financing. She holds a master's degree in finance and entrepreneurial management from the Wharton School of the University of Pennsylvania.