Cash-Value Life Insurance Withdrawals

• If you withdraw money from a cash-value life insurance policy, such as a whole life policy, you may face tax requirements. The taxable amount, if any, depends up your policy basis. You can calculate your basis by adding the amount of money you have paid into your policy and subtracting any dividends or withdrawals you have previously received. Funds that exceed your policy basis come from earnings you have received from your life insurance investment. If you withdraw funds that do not exceed your basis, you typically do not face tax liability. However, if you withdraw more money than the policy basis, you must pay taxes on the funds above the basis amount. For instance, if you have a whole life policy with a $20,000 cash value and a basis of $15,000, you can withdraw $15,000 without facing tax consequences. If you withdrawal $17,000 from the policy, you must pay taxes on $2,000 based on your income tax bracket.
  
  

Death Benefits and Estate Tax

• If you hold ownership of an insurance policy at the time of your death, the death benefit of the policy may become part of your estate. The death benefit increases the amount of your estate, which may leave your beneficiaries liable for both federal estate taxes and state inheritance taxes. According to the Internal Revenue Service, estate taxes apply only to estates valued at $5 millions or more, for deaths that occurred in 2010 or a later date. However, if your life insurance policy increases your estate to a taxable level, your beneficiaries may need to use a portion of the policy's death benefit for taxes.
  
  

Reducing Estate Tax Risk

• You can reduce the risk of estate taxes for your inheritors by transferring the ownership of your life insurance policy to someone other than yourself. The owner of the policy may include the beneficiary of the policy or a trust fund. For example, you can name a brother as the beneficiary of your life insurance policy even if he also stands to inherit all of your estate. This allows your brother to cash the policy for the death benefit, but the cash value of the death benefit will not be included in your estate.
  
  

Death Benefits and Income Tax

• Typically, beneficiaries of life insurance death benefits do not have to pay income taxes on the money they receive. However, if your policy beneficiary elects to receive death benefits in installments, he may face tax consequences. If the insurance company holds funds for installment payments, the death benefit funds will typically earn interest. As the beneficiary receives payments, he may have to pay taxes on interest, typically taxed at regular income rates.