When you surrender a variable universal life insurance policy, you sell off all of the mutual funds in the policy and then cancel the contract. You receive all of the cash surrender value listed in the policy. But, the type of tax you pay on the surrender amount is different from the amount you would pay if you'd invested in mutual funds outside of the policy.
Significance
You will pay ordinary income tax on all of the gains in the contract. This means that any amount you receive in excess of the total premium paid to the policy is treated as a gain subject to income tax. This tax must be paid in the year you receive the cash value of the policy and filed on your next tax return.
Effect
When paying income taxes on the money you receive from your variable life policy, the gain adds to your gross income. This might cause your income for the year to be much higher than it otherwise would be. In turn, you may be pushed into a higher marginal tax rate. Because of this, you may pay a higher average tax than you would otherwise pay. This may result in you receiving much less than you had expected from your insurance policy.
Prevention
To prevent taxation of your policy, you must keep the insurance in force. Variable universal life insurance offers you the opportunity to withdraw money from your cash value or borrow against it. Your insurance company may offer a preferred loan rate. If you keep your policy, you won't pay income tax. In fact, you'll gain access to your policy values on a tax-free basis through policy loans. Withdrawals are tax-free up to your basis in the policy. Your cost basis is the total amount of premiums you've paid into the policy.
Consideration
If your variable policy is not performing well, consider switching the mutual funds to a fixed interest fund. Otherwise, consider transferring the policy into an annuity contract. This can be done without triggering an income tax liability. The transfer is called a 1035 exchange. Once you exchange the policy for an annuity, you cannot reverse the process, so be sure you really want to exchange the policy. If you are not an experienced investor, it may be best to switch to a fixed annuity. This way, you won't lose money in the future, and you allow the insurance company to manage the investments on your behalf. You will get a guaranteed rate of return and can better plan your future.
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