Understanding the Tax Treatment of Cash Value Growth and Withdrawals

You have a permanent life insurance policy with cash value. The cash value is growing. But how is this growth taxed? What happens when you withdraw money? What about loans?

This guide explains the tax treatment of cash value growth and withdrawals from permanent life insurance policies.

What Is Cash Value?

Cash value is money that builds up in permanent life insurance policies. It grows over time and you can access it while you are alive.

Types of permanent life insurance with cash value:

• Whole life insurance
• Universal life insurance
• Variable life insurance
• Indexed universal life insurance

Term life insurance does not have cash value. Only permanent policies build cash value.

How Cash Value Grows

Cash value grows in different ways depending on the policy type:

Whole life insurance:

• Guaranteed growth at a fixed rate
• Dividends (if the company pays them)
• Tax-deferred growth

Universal life insurance:

• Interest credited at current rates
• Tax-deferred growth
• Rates can change

Variable life insurance:

• Grows based on investment performance
• Tax-deferred growth
• Can go up or down

Indexed universal life insurance:

• Grows based on market index performance
• Tax-deferred growth
• Usually has a floor and cap

Tax Treatment of Cash Value Growth

Good news: Cash value growth is tax-deferred. You do not pay taxes on the growth while it is in the policy.

How it works:

• Cash value grows inside the policy
• You do not pay taxes on the growth each year
• Taxes are deferred until you take money out
• This is similar to how 401(k) or IRA growth works

Example: You have a whole life policy. The cash value grows from $10,000 to $15,000 in a year. You do not pay taxes on the $5,000 growth this year. Taxes are deferred.

Tax Treatment of Withdrawals

Withdrawals are taxed differently depending on how you take money out:

1. Withdrawals up to your basis:

• Your basis is the total premiums you paid
• Withdrawals up to your basis are usually tax-free
• This is a return of your premiums

2. Withdrawals above your basis:

• Withdrawals above your basis are taxable
• They are taxed as ordinary income
• This is the growth portion

Example: You paid $50,000 in premiums. Your cash value is $70,000. Your basis is $50,000.

• If you withdraw $30,000: Not taxable (within your basis)
• If you withdraw $60,000: $10,000 is taxable (above your basis)

Tax Treatment of Loans

Policy loans are usually not taxable. You can borrow against your cash value without paying taxes.

How it works:

• You borrow money from your policy
• You do not pay taxes on the loan
• You pay interest on the loan
• The loan reduces your death benefit

Important: If the policy lapses with an outstanding loan, the loan might become taxable. This is a complex area. Consult a tax professional.

Tax Treatment of Surrenders

Surrendering a policy means canceling it and taking the cash value.

Tax treatment:

• Cash value up to your basis: Not taxable
• Cash value above your basis: Taxable as ordinary income

Example: You paid $50,000 in premiums. You surrender the policy and receive $70,000.

• $50,000 is not taxable (your basis)
• $20,000 is taxable as ordinary income

Tax Treatment of Death Benefits

Death benefits are usually not taxable. When you die, your beneficiary receives the death benefit tax-free.

This is separate from cash value. The death benefit includes the cash value, but it is still generally tax-free to beneficiaries.

Common Tax Scenarios

Scenario 1: You withdraw cash value

• Withdrawals up to your basis: Not taxable
• Withdrawals above your basis: Taxable as ordinary income

Scenario 2: You take a policy loan

• Loans are usually not taxable
• Interest paid might be deductible in some cases

Scenario 3: You surrender the policy

• Cash value up to your basis: Not taxable
• Cash value above your basis: Taxable as ordinary income

Scenario 4: You die

• Death benefit is usually not taxable to beneficiaries
• Cash value is included in the death benefit

Important Tax Considerations

Basis tracking: Keep track of your basis (total premiums paid). This helps determine what is taxable.

Policy loans: Loans are usually not taxable, but be careful if the policy lapses.

Surrenders: Surrendering a policy can trigger taxes. Consider the tax implications.

Death benefits: Death benefits are usually tax-free to beneficiaries, regardless of cash value.

State taxes: State tax rules might differ from federal rules. Check your state.

Common Mistakes

Not understanding basis. Your basis is important for tax purposes. Keep track of it.

Assuming all withdrawals are tax-free. Only withdrawals up to your basis are tax-free.

Not considering tax implications of surrenders. Surrendering can trigger taxes.

Not consulting a tax professional. Tax rules are complex. Get professional help.

The Bottom Line

Cash value growth is tax-deferred. You do not pay taxes on growth while it is in the policy.

Withdrawals up to your basis are usually tax-free. Withdrawals above your basis are taxable as ordinary income.

Policy loans are usually not taxable. Death benefits are usually tax-free to beneficiaries.

Need help understanding life insurance tax implications? Visit AgentVerified.com to find a qualified agent near you who can help explain tax rules and find the right life insurance policy for your situation.

Looking for more information about permanent life insurance? Compare life insurance quotes and explore whole life insurance and universal life insurance options.