Surrendering whole life policies

[Carl]

In my somewhat limited experience, when you cash in a whole life policy, be it the entire policy or only part of it, if anything is taxable the insurance company will send you a tax reporting document of some type. I know when I cashed mine in over 10 years ago, I received a 1099-R for the taxable portion of the payout. My taxable portion was basically the dividends that has accrued over the life of the policy.

[billjans]

In my case, additional paid-up insurance was used over a number of years to pay premiums.  When the policy was surrendered, the insurance company considered the value of these to be withdrawals from the policy, which were then subtracted from the premiums paid to determine the basis.

[billjans]

One additional clarification, the additional paid-up insurance was purchased using the dividends received on the base policy.

[Carl]

One additional clarification, the additional paid-up insurance was purchased using the dividends received on the base policy.

What you did with the dividends is irrelevant. It's still taxable income when you cash out the policy.

Now the accuracy of that above statement assumes you had the same type of whole life policy I did. But like I said, if it's taxable/reportable on your tax return, you'll get a 1099-R (or some other tax reporting document) from the insurance company at tax time.

[billjans]

Sorry for the late reply.  For a number of years, paid-up additional insurance was used to pay the premiums.  Upon surrendering the policy, the insurance company considered these payments to be prior withdrawals.  My contention is that the dividends used to purchase the paid-up additional insurance were a reinvestment in the policy and should be added to the basis of the policy, thereby reducing the taxable amount upon surrendering the policy.

[JulieS]

Yes, the dividends used to pay your premiums can be added to the basis of the policy, but only if you reported them as taxable income in the year they were received. 

Did you receive a 1099-DIV from the insurance company for these dividends? If yes, they can be added to your basis. If no, they can't be added to your basis. 

[billjans]

The dividends were used to purchase additional paid-up insurance which was then used to pay premiums.  My understanding is that the IRS position is that "Dividends used to purchase paid-up additional insurance or to pay premiums on the same policy are not taxable. This is because the dividend distribution and simultaneous premium payment, or purchase of paid-up additional insurance, for the same amount will cancel each other out."

[Carl]

"Dividends used to purchase paid-up additional insurance or to pay premiums on the same policy are not taxable.

Actually, it depends on the type of whole life policy one has. For the whole life policy I used to have, if the dividends are never "paid out" and you never sell or cash out the policy, then the statement is true that the dividends are not taxable. But when you cash out the policy, the dividends become taxable not matter what they were used for; be it buying additional insurance or anything else.

Generally, if you cash out a whole life policy and they send you a 1099-R, 1099-DIV or any other type of tax reporting document, then whatever portion of the payout is reported on that document is reportable on the tax return. The taxability of it may very well be a different matter. But it is reportable. Otherwise, they would not have issued the document.

[billjans]

I did get at 1099-R with the taxable amount in Box 2a.  Can you provide an example of when an amount on a 1099-R is reportable but not taxable when a life insurance policy is surrendered?

[Carl]

Can you provide an example of when an amount on a 1099-R is reportable but not taxable when a life insurance policy is surrendered?

Not really. I've only had two whole life policies I've cashed out in my life. Both times a portion (not all) of the cashout was reported on a 1099-R and both times the entire amount reported was taxable. Perhaps another reading this thread can enlighten both of us?

[DianeW777]

The amount you paid for the life insurance would not be taxable if you are the insured. However, if there are earnings on those distributions that have never been taxed then you would have a taxable amount that must be included in your income.

IRS Interview Tool will assist you in your situation (click the link to begin after you see the details).  Gather the requested information below.

• If you are the policy holder who surrendered the life insurance policy for cash,
  • if the amount you received is more than the cost of the policy
• If you are the beneficiary,
  • the face amount of the policy, if specified in the policy
  • if you are receiving the proceeds in installments, whether there is a refund or period-certain guarantee
• If federal income tax was withheld from the life insurance proceeds

Please update if you have more questions.

[billjans]

I am in agreement that the earnings on the distributions should be taxed, but that the dividends are considered a return of premium and should be excluded from taxation.  That is the position I have taken in a recent letter to the insurance company.  The tool is fairly simple, but the answer is that the proceeds should not be taxed.  We shall see what the insurance company says.  I will post their response whenever I get it.

[craigy]

For my unique situation where i surrendered my life insurance policy and reading various other insurance company sources, Dividends are not taxable and should not reduce basis.  The dividends were used to reduce premium payments and earlier i think they were used to purchase paid -up insurance.

I think my insurance company sent me an incorrect 1099-R because they subtracted Total Dividends from my Total Premium Payments to arrive at  a very low  Basis leading to a very high Taxable Amount which essentially comes out to taxing my Dividends.

Insurance references  on the internet say that dividends have no effect on the basis and are a return of premiums and are not taxable.  What is your opinion on this ?

Thank you.

[billjans]

This is exactly my situation.  My insurance company is MetLife.  After several letters back and forth, MetLife has stated the dividends are taxable and will not issue a corrected 1099-R.  My understanding is that without a corrected 1099-R, filing an amended tax return is not possible.  I have been searching for a related IRS letter or ruling that supports my position but have not found one.  I have not given up but so far have not found a way to contest MetLife's position on this issue.  If you are more successful, please post to this thread again.  I will do likewise.

[AmyC]

Dividends are tax free until your basis is used up. Pub 525 states: 

Surrender of policy for cash.

If you surrender a life insurance policy for cash, you must include in income any proceeds that are more than the cost of the life insurance policy. In most cases, your cost (or investment in the contract) is the total of premiums that you paid for the life insurance policy, less any refunded premiums, rebates, dividends, or unrepaid loans that weren’t included in your income.

References:

The IRS has a quick quiz, Are the Life Insurance Proceeds I Received Taxable?

Life Insurance & Disability Insurance Proceeds

@craigy   @billjans