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Question: What are the tax consequences allowing a non-MEC life insurance policy with an existing loan to lapse or be surrendered?
Answer: In taxing policy distributions, the cost recovery rule is used; that is, distributions from a contract are first set off against basis, and generally no tax liability is recognized until basis has been exceeded. This is the reason advisors suggest that income from policies be taken as withdrawals to basis first and loans thereafter.
A non-MEC life policy with loans may, when terminated, create an income tax liability even though little or no cash is received by the owner at termination. This is often referred to as phantom income.
Here’s an example. Assume the policyowner surrenders the following contract.
|Cash surrender value||$8,353.00|
|+ Total loans||+ $66,466.00|
|= Total distribution amount||= $74,819.00|
|– Basis ($3,802 annual premium x 10 years )||
|= Ordinary income||= $ 36,799.00|
The policyholder will receive a check upon surrender for $ 8,353, but may owe income tax in excess of that amount.
Likewise, when a policy simply lapses because it doesn’t have enough cash value to stay in force, any loan balance owed at the time of lapse will be considered to be a taxable distribution.
Situations such as these can result in phantom income with a vengeance.
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