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Cashing out of life insurance

Dear Tax Talk,
I have been paying for whole-life and variable-life insurance policies for the last 13 years, and now have a significant cash-surrender value in the policies. I know term would have been cheaper but, at the time, it seemed prudent to lock in something permanent.

Currently, I am to the point where I no longer really need the insurance. My question is: What are the tax ramifications if I cash the policies in? The surrender values are almost exactly what the total accumulated premium payments have been since the day I took out the policies. -- Mr. L

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Dear Mr. L,
If you've been paying for 13 years for these policies, I hope they should be worth more than what you paid. Otherwise you would have been better off with term policies. While most folks can only afford a term policy, permanent insurance is usually a better investment as the policy grows tax-free, helping to pay the annual premiums, which are not tax-deductible. However, this does not appear to have occurred in your case.

Since your premiums were not deductible when paid, their return from cashing in the policy is not taxable income to you. If the cash-surrender value is more than the premiums you paid cumulatively, the growth would be taxed as ordinary income.

Rather than cashing in the policies, you might want to consider reducing the face value of the policy (i.e., the death benefit). This will reduce the annual insurance cost of the policies while allowing you to maintain a tax-deferred investment.

Bankrate.com's corrections policy -- Posted: Aug. 30 , 2005
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