Advanced Underwriting Consultants

Question of the Day – July 7

Ask the Experts!

The professionals at Advanced Underwriting Consultants (AUC) answer the tax and technical questions posed by producers.  Here’s the question of the day.

Question: How are cash distributions from a non-MEC permanent life policy taxed?

Answer: If a cash value life policy is surrendered in full, the amount received in excess of the aggregate net amount paid—the owner’s basis—is taxable as ordinary income.

A partial distribution—whether taken as a partial withdrawal from a universal life contracts, or a partial surrender from a participating whole life contracts—is treated as a tax-free return of basis first.  After basis has been fully recovered, subsequent distributions are taxed as ordinary income.

A loan is not treated as a distribution at all so long as the policy stays in force.  Any loan balance that exists at the time the contract lapses or is fully surrendered is considered a taxable distribution at that time.

Some have said that the smart way to take money out of a universal life policy is to first take withdrawals up to basis and then take loans thereafter.  So long as the policy stays in force until the tax-free death benefit is paid, the policyowner will not recognize a taxable event with regard to the money received.

Here’s an example with numbers.  Say that George buys a $1 million face amount universal life policy, paying $25,000 per year premium for ten years.  Those premium deposits give George an income tax basis in the policy of $250,000.

At the end of 25 years, George’s policy has $500,000 of cash value.  George takes $50,000 of partial withdrawals for five years, which are tax free and reduce his basis to $0.  George then takes a $100,000 loan against the policy, which is also tax free.

So long as the policy stays in force until George’s death, George will have no tax liability for any of the distributions.  The death benefit will be income tax free to George’s beneficiary.

Have a question for the professionals at AUC?  Feel welcome to submit it by email.  We may post your question and the answer as the question of the day.