Lifetime Uses of Life Insurance Policies

Life insurance is designed to provide a surviving spouse, children, or other beneficiaries with funds after the insured’s death. It can also be used for other important purposes, such as buying out the business interests of the insured and paying estate administration costs. Increasingly, life insurance policies have been used during the life of the insured. Here are some tax rules affecting lifetime uses of these policies.

Policy loans

If you have a policy that builds up cash value, such as a whole or variable life policy, you can borrow against the policy. The loan is easy to arrange; just ask the insurance company for particulars (interest rate, cash value available, etc.).

Good news: Borrowing is a tax-free event; there’s no tax result when you borrow from your policy.

Bad news: If you fail to repay the loan, your beneficiaries won’t have the financial protection you originally intended. What’s more, you may have a serious tax result. Take the following case of Samuel Brach (T.C. Summary Opinion 2013-96), who borrowed against the cash value of his Guardian Life Insurance policy. When he became disabled and unable to keep up loan payments or premiums to keep the policy in force, he became obliged to surrender the policy, and Guardian made a final cash distribution to him. Over the course of owning the policy, he received distributions of $65,903 ($3,786 of which was paid upon surrender). This created taxable income of $33,125, which was the difference between the gross distribution, $65,903, and his investment in the contract (premium payments) of $32,778.

Tapping the policy for long-term care expenses

If an insured becomes ill and needs money to pay for care beyond what his or her health insurance program provides, a life insurance policy may be the answer. It can be cashed in and used to pay for lifetime care.

Good news: Accelerated death benefits may be fully tax free. They are essentially treated as having been paid upon the death of the insured if the insured is terminally ill. If the insured is chronically (but not terminally) ill and needs funds to pay for long-term care, the funds are taxable only if they exceed a per diem amount ($320/day in 2013 and $330/day in 2014) and also exceed the actual cost of such care.

Bad news: Again, the original intent of having the life insurance policy (e.g., to provide for beneficiaries) is thwarted.

Funds for lifetime purposes

If it’s decided that there is no longer a need for the policy, it can be cashed in (surrendered) or sold to raise cash. Surrendering or selling the policy can result in ordinary income, long-term capital gain, or a combination of both.

Good news: Surrendering a term life policy does not trigger any income because no cash is paid; this is a tax-free event.

Bad news: The tax on a sale or surrender of a policy eats into the cash received from this action. Details about the tax consequences of selling or surrendering a life insurance policy can be found in Revenue Ruling 2009-13.

Conclusion

Before taking any action with respect to a life insurance policy, consider both the nontax and tax results. When in doubt, talk to your insurance agent about your options to achieve your desired goals without triggering adverse tax consequences.