If you cash in a life insurance policy, you may need to pay tax on the cash surrender value. Any amount you receive over the amount of premiums you paid is taxable income.
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Calculating the Tax on the Cash Surrender Value of a Life Insurance Policy
Think of your life insurance policy like a savings account that you can withdraw money from. The amount you deposit is yours and you can take it back tax free. The interest is income and is taxed.
For a life insurance policy, your premiums are the deposit. The amount of the cash surrender value above your premium payments is the interest.
Cash Surrender Value: $50,000
– Premiums Paid: $40,000
= Taxable Income: $10,000
How do you pay the taxes?
Your insurance provider may give you the option to have taxes withheld. If not, you will need to make an extra tax payment to the IRS.
You can typically pay the taxes owed when you file your tax return. However, you should be aware of the estimated tax rules. There are some cases where you may need to make a tax payment by the end of the quarter to avoid paying interest if you wait until you file to pay.
The taxable portion of a life insurance policy cash out is ordinary income subject to the same income tax rates as your wages, investment income, and other taxable income. Use a tax calculator to check your withholding, figure out how much money to set aside for taxes, or to check if you need to make an estimated tax payment.
What if you already spent the money and can’t pay the taxes?
If you spent the full amount of the cash surrender value without realizing you’d owe taxes and don’t have money to pay the taxes, the IRS will charge interest and failing to pay penalties until you pay the amount owed. If you can’t pay in full, you may want to consider an installment agreement or other payment options.
Is the cash surrender option a good benefit of buying life insurance?
Having options gives you more flexibility if your plans change in the future. A financial advisor can help you figure out how much having that option might be worth to you and if this is something you should choose when buying life insurance.