Cancelling Life Insurance with Outstanding Policy Loan Can Trigger Tax

Life insurance contracts generally receive highly favorable income tax treatment. One of the more important of these benefits is the tax-free inside build-up of cash value in a policy.  Not only does the cash value accumulate without tax, but this untaxed cash accumulation may be utilized by the policy owner (without current income recognition) by taking a policy loan.

Ordinarily, when a life insurance policy having a cash value is cancelled, surrendered or lapses, there are potential tax consequences.  In general, amounts received by the policy owner upon cancellation or surrender are treated first as recovery of the policy owner`s investment in the policy, and excess amounts received are taxable as ordinary income.

In the event the insured dies, the death benefit (net of any unpaid policy loans) is paid.  This death benefit is excluded from gross income under exception to the general rule.  Furthermore, if the insured has died, any policy loan amount paid out of the death benefit also escapes income taxation.

This avoidance of income recognition does not occur however when the insured has not died, and the policy loan is retired by offset against the cash value in connection with any other surrender, cancellation or lapse of the insurance policy.  To the extent that the policy owner has borrowed funds from the policy in an amount in excess of the premiums paid on the policy, and no longer has any obligation to repay such borrowed funds, there has been a net benefit which is subject to federal income tax.

The surrender or cancellation of a life insurance policy subject to an outstanding policy loan can trigger a significant income tax liability even if little or no cash is received by the policy owner.    If you are considering cancelling or surrendering a life insurance policy you should consult your legal, tax or financial advisor to discuss the potential adverse consequences.  Especially if you have taken a loan on such policy.  Please contact me at 937-223-1130 or if you have any questions concerning possible tax consequences related to life insurance policies.

AND ONE MORE THING.  PS&E Attorney, Fred Hatton has written an excellent article entitled “Considerations for Doing Business Across State Lines.”   Give me a call or email at 937-223-1130 or if you have an issue or topic you would like to see discussed in SenneySays.

AUTHOR: Jeff Senney

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