Single Premium Insurance Tax Question

She did "touch" the interest capitalizations, just not directly. It sounds as though every year she took a small withdrawal in the form of a loan. The insurance carrier charges interest on that loan balance because that treat the withdrawal as if it is still in the policy earning interest (even though it's really in her pocketbook). However, instead of paying the loan interest annually, she took another loan to pay the interest on the former loan. She likely did not actually engage in any action as this process is automatic unless the interest payment is remitted to the insurer by other means (i.e. she writes a check).

Unfortunately, it's time to pay the piper. She invested $10k, withdrew some of the earnings, continued to receive interest on those earnings, did not pay out of pocket interest for that priviledge, enjoyed tax deferred growth, and then cancelled the policy (for which she received $10k-12k). She almost assuredly owes taxes on the $26k. At 20% automatic withholding, that's about $6500 in taxes. Although it's easy to feel bitter, you shouldn't. Had the insurance company reduced her cash value instead of charging interest she would likely have gotten much less in the long run.

Thank you very much. I suspected something like that, but I was not sure.

She originally invested $10K. She withdrew interest over 15 years (how much, in total? Say, 14K?) Now she's getting a final $12K. So her total withdrawals are $26K. So she should owe tax on the net, $16K.

Or were her total withdrawals over the years more like $24K?

Seth

Her total withdrawals were about $9400

So she deposited $10K, and withdrew $9.4K and $11K, totalling $20.4K, and is now supposed to pay taxes on $26K of her $10.4K profit? If this contract were sold as "tax-advantaged" I'd consider that fraud.

Seth

Was that the sum of the checks that she actually received or the amount that the insurance company considers to have given to her? It's the latter that the IRS cares about. As I said previously, every year the interest she capitalized was considered a "withdrawal" even though she likely never received a penny. What was the outstanding loan balance on the policy at the time of surrender? This likely represents the reportable "profit".

And unless I am incorrect (which has been known to happen), you left out the "forgiven" interest she didn't pay on the loan. If the $9400 includes the forgiven interest, then you are likely correct that she only owes taxes on the $10.4k

Another thought occurs to me, but it may only further confuse the matter.

The typical protocol for using life insurance policies to generate income is "withdrawals to basis, then loans". In other words, the insured makes out-of-pocket contributions, which add to basis (in our case $10k). When the insured begins taking income from the policy, the first $10k is a return of basis, not a loan (hence, no tax due). Once basis is zero, loans are accrued from the accumulated cash value and those amounts plus any capitalized loan interest are taxable when the policy is surrendered.

This is apparently not the case, because the OP states there _are_ interest capitalizations and a loan balance yet her total withdrawals were less than basis. Very strange, indeed, given what little facts we have. I will be interested to see clarification from the OP.

The $9400 is the sum of all the checks she received.

I have the following Cash value 36K Loan Payoff 24K Surrender value 12k Taxable Gain 26K I am not sure which once of these =the outstanding loan balance (probably the 24K?)

It does not appear to me that the $9400 includes the "forgiven interest".

Thank you very much again for your help

I am not sure I can add anything except that the rules on such Single Premium Insurance changed sometime during the life of the loan. Apparently, there were some questionable practices involving these accounts so some regulations got added (IIRC).

I think it was not made very clear to my mother how the policy worked. She also got a letter which she understood to mean that she owed 26K. We took this to a financial adviser who straightened this out and my mother decided after talking to him that it would be best just to cash in the policy. At the time, we didn't ask about the tax situtation. Thanks

As I originally expected, she will have a $26k gain. By the way, it's taxed at ordinary income tax rates.

Your mother's $10k investment grew to $36k. She withdrew $9400 in cash. She "withdrew" $14.6k to pay the interest on the $9400. She then received $12k at surrender. All of that, minus her $10k investment, is about $26k in gains.

The rule change you referred to is for policies that were intended to act like investments more so than insurance. They were retitled as "modified endowment contracts" (MECs). While this could have potentially applied to your mother, it doesn't seem to be the case. Regardless, the primary difference between a MEC and a normal life insurance contract is how the cash values are taxed while the policy is inforce. Once surrendered, the end result is the same.

Was the forgiven interest tax-deductible as investment interest? Shouldn't it be carried forward and deducted this year?

Seth

Why isn't the $14.6k of interest deductible?

Seth

First, and for clarification, the interest isn't really forgiven (that's why I used the quotation marks). The situation is akin to taking out loan1 at bank A and then in 1 year, when the annual accrued interest comes due, taking loan2 at the same bank A to pay the interest due on loan1. And then in another year taking loan3 at bank A to pay the interest on loan1 and loan2. Rinse and repeat ad nauseum. That's why $9400 (taken out over many years) snowballed into a $24k loan balance. She simply took out consecutive loans to pay the previous loans and the insurance company aggregated them. This whole process was likely automated.

As to why the interest can't be deducted as investment expense: I can't say with certainty. I suspect it is because a) TEFRA, DEFRA, and TAMRA all aim to ensure that insurance products are clearly defined and separated from investments (so it's not _investment_ interest) and/ or b) I don't believe the investment expense deduction applies to tax qualified accounts. The dividends and interest of an insurance policy grow tax deferred.

Someone else may be better suited to answer your questions, but my experience assures me that the answers are "no" and "no".