How cash value is taxed: withdrawals, loans and surrenders

The cash value inside a permanent life insurance policy grows tax-deferred, so you owe nothing while it accumulates. What you owe when you take money out depends on how: a withdrawal is tax-free until you have recovered your total premiums (your basis), a policy loan is generally not income while the policy stays in force, and surrendering the policy triggers ordinary income tax on any amount above your basis. The governing rule is 26 U.S.C. §72(e), and the exceptions for a modified endowment contracts and the 7-pay test are much harsher.

Growth inside the policy

A policy that meets the definition of life insurance in section 7702 is not taxed each year on its investment gains, interest or dividend credits. The same protection applies to the death benefit, which is excluded from income under §101(a). That deferral is the core tax advantage of whole life and universal life. It is not a tax-free account for every use, and the benefit shrinks if you pay for costly insurance charges that an ordinary taxable account would not have.

Your basis

Basis (or "investment in the contract") is generally the total premiums you have paid, minus any tax-free amounts you have already received, such as non-taxable withdrawals and dividends taken in cash. Your insurer's annual statement or a request to the company will show it. Basis is the number that decides most tax outcomes. See cost basis.

Withdrawals

For an ordinary (non-MEC) policy, §72(e)(5) taxes a partial withdrawal on a "basis first" ordering. You get your own premiums back tax-free until the total you have withdrawn equals your basis. Only withdrawals beyond that are taxable as ordinary income.

An important exception: if a withdrawal reduces the death benefit during the first 15 years of the policy, §7702(f)(7) can require the insurer to treat part of the reduction as coming out of gain first. Ask your insurer before taking money out of a young policy. Withdrawals also lower the death benefit in many policies and can raise the odds of a lapse. See withdrawing cash value from a life insurance policy.

Policy loans

A loan from the insurer, secured by your cash value, is generally not treated as a distribution on an ordinary policy, so it is not taxable income while the policy is in force. You can usually pay it back on your own timetable, but interest accrues, and an unpaid loan is subtracted from the death benefit. The details are in life insurance policy loans: how they work and what they risk, and you can model a loan with the policy loan calculator.

The danger is a lapse or surrender with a loan outstanding. Then the loan is treated as an amount you received, and the gain over basis is taxable even though you may get no cash. This is the "phantom income" trap, and it is the main way that tax-free loan strategies go wrong. Dividends and interest stop covering costs in later years for some policies, and the loan keeps growing.

On a modified endowment contract, loans and withdrawals are taxed gain-first, with an additional 10% tax before age 59½.

Surrender and lapse

When you cancel a policy, you receive the cash surrender value. Your taxable gain is that amount, plus any outstanding loan the insurer cancels, minus your basis. The gain is ordinary income, not a capital gain, and it is reported on Form 1099-R. A loss on a surrender is not deductible. Surrender charges reduce the cash you receive, which can reduce the gain.

A hypothetical example

The following is hypothetical and not a market illustration.

Say Priya has paid $60,000 in premiums into a whole life policy, and the cash surrender value is $80,000. She takes no dividends in cash. Here is what each choice does.

Dividends, interest and other cash

• Policy dividends. The IRS treats dividends on a participating policy as a return of premium, so they are not taxed until total dividends exceed the net premiums you have paid. Interest earned on dividends left on deposit is taxable (IRS Publication 550). See policy dividend.
• Term life. A term policy has no cash value, so these rules do not apply unless it is converted to a permanent policy.
• Variable and indexed products. The same §72 framework applies, but the investment losses and charges can affect basis and whether a surrender produces a gain.

Ways to reduce the tax

1. Take withdrawals before loans, within basis. Withdraw up to your basis for tax-free income, then switch to loans if you intend to keep the policy.
2. Keep the policy in force. The tax on a loan comes due only if the policy ends while a loan is outstanding, so monitor it with annual statements.
3. Use a 1035 exchange. If you want to switch products, a 1035 exchanges: swapping policies without tax moves the cash value without tax.
4. Compare keep, surrender and sell. A sale to a settlement company is taxed in layers; see life settlements: selling your life insurance policy and the keep, surrender or sell your policy?.
5. Avoid a MEC. Staying under the 7-pay limit preserves the favorable loan treatment.

Tax outcomes depend on basis, policy type, loans and age, so have a tax professional review a large surrender, loan or withdrawal before you act.

Key takeaways

• Cash value grows tax-deferred, and the death benefit is income-tax free.
• A withdrawal from an ordinary policy is tax-free up to your basis; amounts above are ordinary income.
• A policy loan is generally not income, but a lapse or surrender with a loan outstanding can create a taxable gain without cash.
• Surrender gains are ordinary income, not capital gains, and losses are not deductible.
• A modified endowment contract flips the order: gain comes out first and a 10% penalty may apply before 59½.