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How are the whole life insurance cash value withdrawals taxed?

How are whole life insurance cash value withdrawals taxed?

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1. Withdrawals are taxed like any other investment...either Capital Gains or Income Tax depending on the investment options and how the contract is set up. If you take out a loan you are not taxed on the money, but you do pay an interest rate. Compare the cash value to the equity in a house As you pay in, it grows. If you want to spend it you either sell the equity and pay taxes on it or borrow against it and pay interest.
2. It will depend upon which country you reside in and where you pay your taxes. In the US any withdrawal you make will typically be tax free up to your basis in the policy. Your basis is the amount of premiums you have paid into the policy, minus any prior dividends paid or previous withdrawals. You already paid income tax on those dollars once, so they won't be taxed again when you withdraw them from the policy. In Canada The withdrawal of part or the total of the cash value in a life insurance policy constitutes a disposition for tax purposes. What this means is that there could be an amount taxable depending on the value of the policy. The amount is usually reported on a T5 slip and no income tax is deducted at source. The taxable amount is the excess of the amount withdrawn over the adjusted cost basis of the policy. In the case of a partial withdrawal, the adjusted cost basis is prorated to reflect the ratio of the partial cash value withdrawn to the total cash value of the policy. The adjusted cost basis of a life insurance policy is basically the cost of the insurance policy for the holder, which in essence corresponds to the total of the premiums paid, minus the net cost of pure insurance. The adjusted cost basis is calculated by the issuer of the policy. You have to refer to your particular contract to determine what would happen to your policy if you were to withdraw some of the cash value. Usually, a partial withdrawal will not cause the policy to expire in comparison to a total surrender of the policy. So there is no quick easy answer. It might depend on the location and the policy itself.
3. You can't make a 'withdrawal'. Either you borrow money - up to a percentage of the cash value, usually 80%, or you cancel the policy and take the cash value. If you get more money out, in cash value, than you've paid in, over all those years, that is a capital gain, and taxed as a long term capital gain. If you don't get more money out, than you've paid in, then it's not a taxable event - and you cannot write off the difference as a loss. It's pretty uncommon for a whole life policy, when it's cancelled and the cash surrender value is taken - to exceed the total premiums paid in, unless you've owned the policy for more than thirty years or so.
4. MB is right. You only get taxed if you get more money out of the policy than you paid in premiums. That is rare but can happen if you have had the policy a long, long time. Please post more questions if you have them.
5. If you live in the United States, there are 2 tax reform acts you should know about: 1) 1984 Tax Reform Act: The act says that the cash value in a contract can build no faster than to equal to the face value when the insured reaches age 95. If any policy builds cash value more rapidly than this benchmark, it loses most or all of its tax advantages such as tax deferred growth and no income tax on death benefit. 2) 1988 Tax Reform Act: This law says that if a policy creates a cash value faster than that of 7-pay Whole Life Policy (meaning in 7 years, the cash value should not be worth more than what it is suppose to be), then the policy is a Modified Endowment Contract. Whether its Whole Life, Universal Life, or Variable Life, if the cash value grows faster than a 7-Pay Whole Life policy, then any loan or withdrawal must be made with the understanding that taxable dollars comes out first, then the return premium (which are made with after-tax dollars) dollars. Furthermore, there is a 10% penalty in addition to any taxes due on all withdrawals prior to age 59 1/2. Anyway, I have never seen a whole life policy where cash value is more than total premiums paid, so its very likely that you are not affected by this rule. I have also never seen a whole life policy where you can take withdrawals of the cash value. You can borrow it and pay interest of around 8%. When you pay it back, the interest goes to the insurance company, not to the cash value. If you decide to cancel the policy someday while there's a loan balance due, you will be responsible for income tax on the remaining balance. Before I replace any cash value life insurance policies with term insurance or do a 1035 exchange into a variable annuity, I always make sure that the client pays it back to avoid taxes. If you die someday while there's a loan balance due, this amount plus interest plus any missed premiums will be deducted from the face amount of the policy. No income tax will be owed if this happens, unless the policy is a modified endowment.
6. Chris C used a bad example to explain growth in equity. Your cash value in your policy will grow as you make payments or deposits on top of any loan payments, but the equity on a house might grow as you make payments to your mortgage; It is the market that decides if the equity on a house goes up or down; just look at the actual situation of million of houses that had equity and the market wiped it out. If you decide to widraw from your cash value, you will not pay tax if the accumulated amount you widraw does not go over the accumulated amount you have deposited or paid into your policy.