Q: Over 40 years ago my husband and I purchased whole life insurance policies. Over time we took out policies on our children as well. We didn't always have enough money to pay the premiums so our agent suggested we borrow from some policies to pay premiums on others. We've been doing this for years now and the loans against the policies are large. We are retired now and still paying every month for these policies. We'd like to get out from under the premium payments, but have been told that we would have to pay taxes on the loans. If we pay off each policy and then cash them in, would we owe taxes on the cash value? Thank you for the help.
A: To the extent that the cash surrender value from whole life insurance policies represents earnings that have not been taxed, the proceeds are taxable. The cash surrender value of a life insurance policy consists of two parts: the net premiums you have paid in and earnings on those premiums.
The portion of the proceeds from the policies representing the premiums that you paid is not taxable. It is a return of your investment in the policy. The portion consisting of untaxed earnings is taxable.
Your insurance agent should be able to tell you how much of the net proceeds from the surrender of the policies will be subject to tax. That way you will be able to determine how much tax you may owe so that you can set the money aside. You may also want to discuss whether you will need to repay the loans prior to cashing out the policies or if the loans can be repaid from the proceeds.
You may need to make federal and state estimated tax payments if the additional tax on the earnings from the policies is substantial. Consult your tax advisor if you are concerned about how much additional tax you may owe.