Tax treatment of Cash Values
MR. WATSON: Once again, the cash values are invested by the company and earn interest. This interest is not taxable as long as it remains in the policy. Loans are not taxable. So, you paid in $5,000 and you have cash value that has grown to $15,000. It has grown with interest. As long as it stays in the policy the cash will not be taxed. But, if you cash it in, do you have a gain?
ALL: Yes, $10,000.
MR. WATSON: How could I have received my money tax-free?
MAN: Borrow against it.
MR. WATSON: You can borrow the $15,000 of cash value. Do y'all agree?
ALL: Yes.
MR. WATSON: Mel cashes in his policy for $28,000. How much did he pay in premiums? $19,000. What's his gain? $9,000. How could he have received his money tax-free? Borrowed against it.
Loans vs Withdrawals
- Loans - not taxed
- Complete Surrender/Cash in - excess over cost basis would be taxed
- Withdrawals - excess over cost basis would be taxed
MR. WATSON: Loans are not taxed. Withdrawals can be taxed. Remember, only universal life policies allow for withdrawals. With any other policy you must either cash the policy in or take a loan against the cash value. A withdrawal can also be a partial surrender whereby the policyowner surrenders part of her policy's face amount.
MR. WATSON: Partial surrenders are taxed as "ordinary income" according to FIFO, first in, first out. So when you withdraw from cash value life insurance your principal is taken out first, and anything in excess of that is taxable as income. If you put in $5000 the first $5000 you withdrawal is NOT taxed. Once again, (total premiums paid in less any policy dividends equals the "cost basis." Anything above that is taxed.) If a policyowner paid $5000 in premiums and withdrew $7000, then the excess above her cost would be taxed, in this case $2000.
First-in, First-out - FIFO
- applies to withdrawals
- cost comes out first
Cost Basis
MR. WATSON: How do we determine our "cost basis"? What the actual cost is?
WOMAN: Total amount of premiums paid, less policy dividends. Because dividends, from a mutual company, are a return of premiums.
MR. WATSON: Right on! Know the chart below.
