by swallow_yu » Thu Sep 30, 2010 09:19 am
"But if at any time prior to the insured's death, the loan and unpaid interest exceeds the current cash value of the policy, the policy will lapse (no collateral to cover the debt). In that case, there could be an additional tax implication..."
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I'm considering to take a loan against my whole life policy now. It's been 15 yrs now. Which tax I need to pay if I fail to pay back and my policy goes lapsed? income tax or capital gain tax? I was told I could do partial withdrawal on the principal with no tax at all first. Is that correct?
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I'm considering to take a loan against my whole life policy now. It's been 15 yrs now. Which tax I need to pay if I fail to pay back and my policy goes lapsed? income tax or capital gain tax? I was told I could do partial withdrawal on the principal with no tax at all first. Is that correct?
Posted: Fri Oct 01, 2010 12:20 pm Post Subject:
Income tax. Insurance contracts, like retirement accounts, are not subject to capital gains taxes.
Income tax on a life insurance policy loan and interest is only due on any gain over cost basis (premiums paid) at the time a policy lapses (or in certain cases, endows).
I was told I could do partial withdrawal on the principal with no tax at all first. Is that correct?
It is and it isn't. It is, when the statement is in response to the question, "Do I have access to the cash value without a current tax liability as long as the policy remains in force?" It is not correct when the proper question is asked, "Are all withdrawals or loans from a life insurance policy always income tax-free?"
Agents commonly misrepresent the taxability of insurance cash value. Some do it deliberately to make a sale (they should be shot, or worse). Others do it because they are either (1) unknowledgeable when it come to taxation, or (2) merely repeating what they heard someone else say. Either way it is a problem for the insured when they have a taxable event they thought was not possible.
Fortunately, for most folks, the situation never arises, because most policies do not accumulate gains over basis. Those that do tend not to lapse.
It was a big problem in the 1980s and 1990s when Universal Life policies that no one paid premiums for, having made large transfers of cash value from Whole Life policies through 1035 Exchanges, or persons who made large initial premium payments, because agents were touting "vanishing premiums" -- the policy will pay for itself -- and when interest rates came back down to more reasonable single digits, failure to pay premiums resulted in depletion of cash value.
When the policies began lapsing as the result of no cash value and no premium payments, due to prior high interest credits there was more money taken out (even though never touched by the policyowner) than originally paid in. And big tax liabilities that got people in big trouble with the IRS. And insurance companies paid dearly for the problems they created.
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