The most obvious benefit to life insurance is the death benefit -- what your beneficiaries receive when you die. However, some policies, such as whole life policies, have an investment component that lets you build cash value inside the policy that you can withdraw while you're still alive. Depending on your circumstances, you might have to pay income taxes on part of your withdrawal.
Calculating the Taxable Income
When you take a withdrawal from the cash value of your life insurance, you won't pay any income taxes as long as the amount you cash out doesn't exceed the amount you've paid into the policy in premiums, also known as your basis. However, if you withdraw more than your basis and dip into your earnings, you pay taxes on the earnings portion of your cash out. For example, say you've paid in $22,000 in premiums over the years and the cash value of your account is $29,000. The first $22,000 you take out is tax-free, but the last $7,000 counts as taxable income.
Tax Rates on Distributions
If some of your cash out of your life insurance policy is taxable, you pay taxes on that income at your ordinary income tax rate. For example, if $3,500 is taxable and you fall in the 15 percent tax bracket, you pay an extra $525 in income taxes that year. Even if the money in the life insurance policy was held in stocks or other assets that qualify for the lower long-term capital gains tax rates, your distributions always count as ordinary income.
Other Costs of Cashing Out
Tax implications aren't the only thing to consider when you cash out your life insurance policy. First, the amount you cash out reduces the benefit left for your beneficiaries when you die. For example, say you have a policy with a $500,000 death benefit and you take out $150,000 from the cash value. When you die, your beneficiaries will only receive $350,000. Second, you might also have to pay a surrender charge to the life insurance company, depending on how long you have owned the policy and the terms of your policy.
Rather than cashing out, consider taking a loan against the cash value of your life insurance policy. The loan will accrue interest, but none of the loan is taxable as long as the policy remains in force. However, if you let the policy lapse, the balance of the loan, including any interest, is treated as a distribution to you even though you don't receive any additional cash. For example, say you borrow $100,000 from a policy for which you have paid $90,000 in premiums. If the policy lapses, you owe income taxes on $10,000.
Based in the Kansas City area, Mike specializes in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."