It can be tempting to tap into the cash value of a life insurance that has been accumulating for many years. However, unlike normal investment accounts, accessing life insurance cash value is not a straightforward process. There are three ways to access your cash value: surrender, policy loan, or a secured loan. Each method has implications that should be fully understood as they can have a serious impact on your tax bill.
Surrendering Your Policy
When you surrender your life insurance policy, it is considered to be a disposition of the policy for tax purposes. There are two scenarios in which there would not be a taxable event when a life insurance policy is surrendered:
- If the life insurance policy has no cash surrender value
- If the ACB of the policy is greater than the cash surrender value. In this situation the cash surrender value is paid out without any taxable gains.
Taxable gains apply in situations where the life cash surrender value of the life insurance policy is an amount greater than the ACB of the policy. In this situation, any amount above and beyond the ACB is considered to be taxable income. For example:
The ACB of a life insurance policy is $5,000 and it has a cash surrender value (CSV) of $8,500. If the policy owner surrenders the policy, they will be taxed on the difference between the ACB and CSV: $8,500-$5000=$3,500. The policy owner will have to add $3,500 to their taxable income for the year.
*It is possible to do a partial surrender of a policy and the tax implications are similar to those stated above.
Once a policy is surrendered, the owner loses their entitlement to any death benefits under that policy. It is important that policy owners do an in-depth analysis of their insurance situation to determine if it is worth losing the death benefit. Another consideration is what the policy owner’s health is like at the time of surrender. Individuals in poor health or with medical conditions that would hinder them from acquiring new insurance should think twice before cashing out their policy.
Policy loans are typically a contractual right on most permanent life insurance policies. Life insurance policy loans allow policy owners to access their cash value without relinquishing the death benefit. Unlike a regular loan, policy loans are typically straightforward to get and do not require any extensive applications or requirements. Policy loans do not technically have to be paid back but they do charge interest which will accumulate on top of your loan.
Policy loans have similar tax implications to surrendering a life insurance policy. Any amount loaned above the ACB is taxable income to the policy owner.
Interest on policy loans is also deductible to the policy owner if the funds are being used to earn income in business or a property.
Policy loans allow access to the cash value without cancelling the policy outright. However, if the loan remains outstanding at the time of the insured death then the death benefit will be reduced by the total amount of the loan at that time. It is also important to understand that while policy owners are not required to make payments back into the policy, it is possible that the interest accumulates to a point that the policy can no longer sustain itself. In this situation it may be required that the policy owner start making payments into the policy to cover the interest or the policy may be at risk of lapsing.
Life insurance cash value is considered to be an asset of the policy owner and therefore it can be used as collateral on secured loans. There are many financial institutions that will issue lines of credit up to a certain percentage of a policy cash value (usually 50%-75%). Interest does accumulate on the loan. Depending on the loan contract, the policy owner may have the option to defer payment of the interest until their death, at which time the death benefit of the policy will cover any outstanding interest.
Secured loans are a popular option for accessing cash value because there are no tax consequences when the loan is issued. In fact, the interest from the secured loan may be deductible if it is being used to earn income.
Secured loans are a separate entity from the life insurance policy and therefore there are no immediate implications to the actual policy. When the insured on the policy dies, the secured loan must be given back before any benefits are paid to the policy beneficiaries.
It is always best to consult a tax professional before making any decisions regarding the cash value of your policy. Not only are there tax implications that need to be considered, but any additional income can affect government benefits and should therefore be taken strategically.