Whole life insurance is a permanent insurance policy that also offers an investment component, known as the cash value of the policy. You can tap the cash value through withdrawals or loans, depending on the terms of your policy. However, different options for accessing the cash value of life insurance can be taxable, which you should consider before making your decision.
TL;DR (Too Long; Didn't Read)
Generally, if you withdraw from an insurance policy with a cash value, then you are responsible for taxes on the withdrawal.
Determine Your Basis
The first thing you need to know about your whole life policy is your basis, which is what you've put into the policy, because that allows you to determine whether a withdrawal will be taxable. To figure your basis, total how much money you've put into the policy over the years through premium payments and then subtract any previous distributions or dividends you received. For example, say you've paid $10,000 in premiums and received $1,500 in prior distributions. Your basis is $8,500.
Calculate the Taxable Portion
To figure the taxable portion of your life insurance withdrawal, subtract your basis from the amount you're withdrawing. If the result is negative, you don't owe any taxes because your basis exceeds your distribution. But if the result is positive, that's the amount of taxable income you must report. For example, if your basis is $8,500 and you withdraw $5,000, subtract $8,500 from $5,000 and you get negative $3,500, which means you have $3,500 of basis left after your distribution. But, if you take out $11,500, when you subtract $8,500, you get $3,000, meaning you must report $3,000 of taxable income.
Tax Rates on Life Insurance Withdrawals
Any life insurance benefit taxable income from your whole life insurance policy withdrawal is taxed at ordinary income rates – the same rates that are used to calculate taxes on your wages or salary. For example, if your income puts you in the 24 percent tax bracket, that's the rate you pay on the taxable portion of your life insurance withdrawal. Though whole life polices may invest some of the cash value in stocks or other capital assets, you can't take advantage of the lower capital gains rates on your withdrawal.
No Immediate Taxes on Loans
Some whole life policies may allow you to borrow against the cash value of your life insurance policy rather than taking a withdrawal. Loans are not taxable, so you won't owe any income taxes provided your policy remains active. However, if you miss premiums and the policy terminates, or you surrender the life insurance, the loan immediately becomes a withdrawal, and these life insurance proceeds are now taxable. In addition, if you die with a loan outstanding, your death benefit is reduced by the balance of the loan.
Understand the 1099-R
When you withdraw money from a whole life insurance policy, the insurance company should send you a 1099-R form to be used when doing your income taxes for that tax year. The total amount of your withdrawal, or Gross Distribution, will be in Box 1. The taxable amount will be in Box 2a. If there was federal tax withheld before you received the money, this will appear in Box 4, while any state tax withheld will be in Box 12.
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