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Cancel whole life insurance policy, and tax-deferred earnings are taxable

My whole life insurance policy has a $35,000 accrual. Having been recently disabled, I’d like cancel my policy and recover the funds for use now. What are the tax implications of the whole life payout?

A whole life policy combines insurance with a tax-deferred investment, or “cash value.” If you cancel the policy, your payout is your cash value minus outstanding policy loans.

That payout — let’s say it’s $35,000 — is taxable as ordinary income to the extent that it exceeds premiums you’ve paid minus any dividends you’ve received. For example, if you paid $26,000 in premiums and received $5,000 in dividends from your investment, you’ll owe taxes on $35,000 minus $21,000 — i.e., $14,000.

Cashing out isn’t the only way to tap a policy’s value. If a series of payments would address your needs better than a lump-sum payment, you might consider converting the policy into an income-paying annuity. (In that case, comparison-shop for the annuity; you can choose one from any insurer, not just your current carrier.) The conversion, called a 1035 exchange, is tax-free; but part of each annuity payment will be taxable.

Another option is taking a policy loan — i.e., using your cash value as collateral to borrow from the insurer. Loan proceeds generally aren’t taxable. Interest on the loan can be added to the amount you owe; and it may be partly offset by your cash value’s earnings. But any unpaid loan at your death reduces the policy benefit for your heirs. And in the worst-case scenario, if your loan balance grows to equal your cash value, the insurer terminates the policy, taking the cash value to recoup the loan — and that leaves you owing taxes on the entire amount.

THE BOTTOM LINE When you cancel a whole life insurance policy, its tax-deferred earnings become taxable.

WEBSITES WITH MORE INFORMATION

dfs.ny.gov/consumer/que_top10/que_life_who.htm

kitces.com/blog/cash-value-life-insurance-policy-loan-rescue-strategies-to-avoid-taxable-lapse

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