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 have different income tax consequences, which you should consider before making your decision.
Determining 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.
Calculating Taxable Withdrawal
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 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 25 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. If you take a loan, you won't owe any income taxes because you're not taking out any of the cash value. However, if your policy terminates, the amount of the loan (including any accrued interest) counts as a distribution -- which could be taxable. In addition, if you die with a loan outstanding, your death benefit is reduced by the balance of the loan.
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