Life insurance-cash value

[Bird Legs]

Client-retired, has several life insurance policies with cash value. He is thinking about
cancelling the policies and taking the cash value and investing it someplace. If this
occurs, how is the money received from the life insurance taxed?
Have not had this before. My assumption is that it would be just ordinary income
and taxed as such.
Also, is there a way to defer the tax on this?
Thanks for all your help in the past and in the future.

[sea-tax]

Client-retired, has several life insurance policies with cash value. He is thinking about
cancelling the policies and taking the cash value and investing it someplace. If this
occurs, how is the money received from the life insurance taxed?
Have not had this before. My assumption is that it would be just ordinary income
and taxed as such.
Also, is there a way to defer the tax on this?
Thanks for all your help in the past and in the future.

Bird Legs,
Don't quote me on this because I have never sold a policy like that. They are usually not in the clients best interest. I would think and it is just a thought that the Premium amount would not be taxed, only the appreciation on the original amount contributed. This would apply if it were purchased outside a tax defered vehicle. In essence if the client has made 25k in premium payments but the actual cash value is 30k then he would have a 5k taxable value.
Just a shot but , would love to hear if anyone else agrees or disagrees.

[Snaggletoof]

Minimal Taxation

Bird Legs, I'll give you my take on taxation of cash value life insurance -- a classic institutional approach to investing which clearly is not in the best interest of the subscriber. There's been a lot of talk on the board about those kind of financial products in the last few days, and cash value life insurance is just about as bad as it gets.

There is absolutely no taxation until such point as the subscriber's cash value exceeds his cumulative investment. On a typical product, a $100,000 face value may cost $25 per month at a young age, or $300 per year. After 10 years, Stupid has sunk $3000 into this idiocy and may have a cash value of $2400. No taxation yet.

After 15 years, Stupid has accumulated an investment of $4500 into this policy. And now his cash value is $4500. From now on there will be taxation. In his 16th year, Stupid invests another $300, for a cumulative investment of $4800. His cash value, however, is now $4825, and is finally accumulating faster than his premiums. In this example, Stupid has taxability of $25 in his 16th year, and this will gradually increase from now on. Stupid also has BASIS of $4825 in this policy, $4800 of his own money, and $25 that he has been taxed on. This means that if he cashes out his policy for $4825, there is no taxation.

Insurance company is obligated to send Stupid a 1099-INT for $25, and this assures his basis remains the same as the cashout value. Over the years, he should receive a 1099-INT every year. Note that under no circumstance does the $100,000 face value ever enter into the picture -- it is irrelevant. The only measure of taxation is the amount the cash value exceeds the cumulative investment.

Generous tax law? You might think so because the tax consequences are zero, or at worst negligible. But if you look at the total picture, the taxation is identical to that of any investment in terms of return and access to principle. Most cash value policies pay a ridiculously low return, and if your taxation is very small it is only because your real return is very small as well.

[DaveO]

I think the tax bit would be a bit more.

Part of each premium payment is for insurance, commissions and cash value. That's why the cash value grows slowly at first. Only the cash value part of each payment would become part of the basis. The interest credited to the account wouldn't be currently taxable unless it can be withdrawn. The total accrued interest would be taxable on surrender of the policy.

[Snaggletoof]

Don't Think So

DaveO, you're one of our better folks, so I thought twice before taking a position contrary to yours.

I believe a cash value policy is deemed to be "accessible" for cash purposes, meaning the cash value "can be withdrawn." This means the cumulative excess of cash value over the cumulative premiums is the measure of taxation, and some taxation should occur every year.

The fact that the insurance company divides the customers premium into risk, commission, profit, or any number of items does not affect the customers' investment. If the customer pays $10,000 over the course of several years, that is his investment. Doesn't matter if the insurance company divides the $10,000 into several different cost centers, etc.

[BOB W]

Life insurance.,,,

.....is a poor investment but it provided money for a family or other insured protection. Playing the stock market, as many have found out in 2000- 2004 was also another poor investment. In the stock market you can also loose principle. But you all are correct, life insurance is a very conservative low yeilding investment.

Most life insurance policies only stay in force for 7 year. At the seven year mark most policies have taken in more money than its cash value. After 10 years they are just about even. By the time they are in force for 20 year, they are now paying a substantial return on each new dollar paid into the policy.

Before an old policy is cashed in in would pay to evaluate what you are getting in new Cash Value, including dividends, for each dollar invested. Some policies can get 10% or more return on the new invested dollar.

As a whole, life insurance policies will yeild a 3-4% return. As you say, the beginning years are a loss, but the later years can be hefty ( a relative word based on current interest rate) in order to achieve that 3-4% overall yield.

Just a note : A standard whole life insurance policy's Cash Vaule is set to reach its face value at age 99. Every year that the policy is in force the insurance company pays out less of their money because more of your money is in the policy.

Policy loans are available. In the past you could borrow up to 95% of the cash value and pay interest based on the terms of the policy. Some older policies had a 5% loan rate but I think newer policies are higher and possibly tied to prime+. Policy loans are not taxable income.

[S T]

Taxable

Found this which might help in the taxability of insurance and cash values.

To calculate taxable income on the surrender of the life insurance policy, run the following calculation:
Surrender amount
minus previously taxed interest left with the insurance company
minus previously taxed dividends left with the insurance company(if any)
minus total premiums paid over the life of the policy.
Equals net gain or loss.
If the result is a positive number, it is taxable as ordinary income.
If a negative number, you owe no tax.

In looking further it really depends on the type of policy that was originally issued as to how dividends, interest and surrender might be taxable.

Are dividends taxable?
An insurance dividend, unlike a stock dividend, is usually considered a return of premium, and as such is not taxable income until dividends received exceed premiums paid. If dividends are left to accumulate at interest, however, the interest credited each year is taxable income, which must be reported to the Internal Revenue Service (IRS) each year.

I remember a some years back we used to receive either 1099 int or 1099 div from insurance companies.

There are circumstances when dividends are not considered a return of premium and, therefore, are taxable. One such circumstance involves policies where large amounts of additional premium have been added to the policy. These policies are classified with the IRS as Modified Endowment Contracts (MEC) and are considered savings vehicles rather than life insurance. Under these policies, the dividends are taxable as income to the policyholder, to the extent there is gain in the policy. The only exceptions are for dividends applied to reduce the policy premium or to purchase additional insurance under the policy

Here is a link from AICPA that might shed more light on the subject http://pfp.aicpa.org/Resources/Perso...+Insurance.htm Basis

The surrender of your policy may result in taxable gain

If you surrender your cash value life insurance policy, any gain on the policy will be subject to federal (and possibly state) income tax. The gain on the surrender of a cash value policy is the difference between the gross cash value paid out (plus any loans outstanding) and your basis in the policy. Your basis is the total premiums that you paid in cash, minus any policy dividends and tax-free withdrawals that you made.

Do we think that our t/p kept track all these years???

Bird, I think depending on the policy and what the reinvestment is, there is a way to defer any tax, 1035 exchange into another policy or annuity.

Sandy