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Is a whole life insurance cash value taxable? Spoiler: Yes. But find out how to calculate the taxable amount.
I cashed in my whole life insurance policy last year and received a T5 suggesting I have to pay tax on the full amount of my cash value. Is this correct? The cash surrender value was $27,000, I paid $28,000 in premiums, and they told me my pure cost of net insurance was $30,000, whatever that means. It doesn’t make sense to me! When I purchased the policy, I was told I could use this money for my retirement. I don’t remember the insurance agent ever saying anything about tax.
—Rasheed
Ah, Rasheed, I am sorry to tell you the insurance company is correct. I am glad you asked this question because it serves as a warning to anyone who owns a whole life insurance policy. Before cancelling a whole life insurance policy, contact the insurance company or your agent, and ask what the taxable amount will be. You are also wondering how much is taxable.
Many people assume the insurance cash value is just like any other investment—50% of a capital gain is taxable according to your income tax bracket. You paid $28,000 in premiums and the cash value is now worth $27,000, and you’re thinking you put in more than you made so there should be no tax.
Even if the cash value was worth $38,000, and you paid $28,000 in premiums, you may think you made a $10,000 gain ($38,000 – $28,000 = $10,000) and expect to pay income tax on half of the $10,000 earned. That is not how it works.
Insurance companies generally use this formula to determine the taxable amount of the cash value, cash surrender value (CSV) minus the adjusted cost base (ACB). The ACB is equal to the premiums paid “minus” the net cost of pure insurance. To understand the formula, you need to understand the term net cost of pure insurance, which also means understanding what happens with your whole life premium payments. (“Pure” means the actual cost of the insurance.)
Here is how to calculate the taxable gain:
CSV – ACB = Taxable amount
Whole life insurance is designed to last your entire life, hence the very appropriate name “whole life.” If you were to pay premiums every year based on your age, the premiums would increase exponentially as you get older. When you’re young and healthy, you would expect to pay less than you would when you’re age 85 and closer to death.
The problem with paying premiums based on your current age is that the premiums would become excessively expensive as you get older. And there comes a point when you’d likely cancel the policy because it is just too expensive.
The designed solution is to pay premiums in excess of the actual cost of insurance (net cost of pure insurance) in your early years, so that can be invested (the cash value) and used to help pay for the actual cost of insurance in later years.
To calculate the taxable amount, you first have figure out the ACB of your cash value. And it is unlikely you will have the information on hand. You will need to contact your insurance provider to get it. The good news: You don’t have to calculate the ACB, because the insurance company will do that for you.
However, there could be a problem with the insurance company providing you the ACB. Not that it will be wrong, but you may question it if you don’t understand how it’s calculated.
In your case, Rasheed, you paid $28,000 in premiums and the total cost of the “net cost of pure insurance” was $30,000. Now, rather than having an ACB of minus $2,000, the ACB is set at $0.
When you apply the taxable gain formula (CSV minus – ACB), the amount taxable is $27,000 minus $0. And you get $27,000. That amount is taxable, and it is not considered a capital gain.
In general, after 20 years, about half of the cash value of a whole life policy will be taxable. And after 40 years the total cash value will be taxable.
Rasheed, you are not the only one that’s been caught off guard by this type of tax notice. And it not only occurs when a policy is cancelled. You will also pay tax if you borrow from the policy in excess of the ACB.
My final tip: Always, always call the insurance company or your advisor to find the taxable amount before cancelling or borrowing from a whole life policy. And, yes, there can even be tax on the amount you borrow from the cash value.
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Borrowing from the cash value of the policy above the ACB as a taxable event in the year received…such borrowing would be best done in a year when one’s taxable income is lower. What about further comment on paying back the policy loan in a year when one’s income is in the highest tax bracket and taking a deduction against that higher income in the tax year that the policy loan is repaid? Is that still permitted?
Due to the large volume of comments we receive, we regret that we are unable to respond directly to each one. We invite you to email your question to [email protected], where it will be considered for a future response by one of our expert columnists. For personal advice, we suggest consulting with your financial institution or a qualified advisor.