Understanding how distributions are made and their tax treatment is important to knowing how and when you should take them.
Partial surrenders vs. policy loans
You can withdraw money from your policy’s cash surrender value by requesting a partial surrender — up to the amount of premiums you have paid — tax-free.
This reduces the policy’s accumulation value and the policy’s death benefit. Because of the Internal Revenue Code (IRC) tax treatment of distributions from life insurance contracts — first in, first out — you can withdraw the cost basis first before you take out the gain.
Once you have withdrawn the cost basis from a life insurance contract, any further withdrawals would cause taxation at ordinary income tax rates. In order to avoid taxation on the distributions over the cost basis, you can borrow money from the life insurance company using the gain in the policy as collateral. Since an obligation to repay the loan remains, a loan does not cause taxation to the policyholder.
Policy loans and withdrawals may create an adverse tax result in the event of a lapse or policy surrender and will reduce both the surrender value and death benefit.
In our next blogpost, we will show you how withdrawals are taxed.