What Portion of a Universal Life Withdrawal Is Taxed?

Universal life insurance provides a financial safety net through its death benefit while also building a cash value component over time. This cash value is an asset that policyholders can access during their lifetime, often through withdrawals. A frequent point of confusion for policyholders is understanding the tax implications of taking money out of their policy. The tax treatment is not uniform and depends on several factors related to the policy’s funding and the amount withdrawn.

Determining the Cost Basis of Your Policy

Before the tax consequences of a withdrawal can be understood, you must first determine the policy’s cost basis. The cost basis is the total sum of premiums you have paid into the contract since its inception. This figure represents the after-tax money you have invested in the policy.

Calculating your cost basis is a straightforward process of addition. You simply total all the premium payments made over the life of the policy. It is important to note how dividends affect this calculation: dividends paid to you in cash reduce your cost basis, as they are considered a return of premium. However, dividends used to pay premiums or to purchase additional insurance do not.

The most reliable place to find the necessary information to calculate your cost basis is on your annual policy statement provided by the insurance company. These statements typically itemize the premiums paid for the year and often provide a cumulative total. If this information is not clear on the statement, you can contact your insurance provider directly, and they can supply the exact figure for your policy’s cost basis.

The General Tax Rule for Withdrawals

For most universal life insurance policies, the tax treatment of withdrawals follows a principle known as First-In, First-Out (FIFO). This means that the first dollars withdrawn from the policy are considered a return of your cost basis. As long as your total withdrawals do not exceed the total amount of premiums you have paid into the policy, the money you receive is tax-free. You are essentially taking back your own after-tax contributions first.

The tax liability only arises when you have exhausted your entire cost basis. Any amount withdrawn beyond your total premium payments is considered a gain. These gains, which represent the accumulated interest and investment earnings within the policy, are subject to taxation as ordinary income, not as capital gains. This distinction is meaningful, as ordinary income tax rates are typically higher than long-term capital gains rates.

To illustrate this, consider a policy with a cash value of $120,000 and a cost basis of $80,000 from paid premiums. If the policyholder decides to withdraw $95,000, the tax implications are split. The first $80,000 of the withdrawal is treated as a tax-free return of the cost basis. The remaining $15,000 is considered a gain and will be reported as taxable ordinary income for that year.

Taxation Under Modified Endowment Contract Rules

The FIFO tax treatment can be lost if a life insurance policy is classified as a Modified Endowment Contract (MEC). A policy becomes an MEC if the total premiums paid into it during the first seven years exceed the limits set by federal tax law. This rule, known as the “7-pay test,” was established to prevent the use of life insurance primarily as a tax-sheltered investment vehicle. Once a policy fails the 7-pay test and becomes an MEC, its status is irreversible.

When a policy is designated as an MEC, the tax rules for withdrawals are inverted to a Last-In, First-Out (LIFO) basis. Under LIFO, any withdrawal is first considered to be from the policy’s earnings or gains. This means the very first dollar you withdraw is taxable as ordinary income, up to the full amount of the gain in the contract. Only after all the gains have been withdrawn and taxed can you begin to access your cost basis tax-free.

This LIFO treatment significantly changes the tax outcome of a withdrawal. Using a similar example, imagine a policy with a $120,000 cash value and an $80,000 cost basis that is classified as an MEC. The policy has a $40,000 gain. If the policyholder withdraws $30,000, the entire $30,000 is treated as taxable ordinary income because it is less than the total gain in the policy. This is a direct contrast to a non-MEC policy, where such a withdrawal would be entirely tax-free.

Furthermore, distributions from an MEC, including both withdrawals and policy loans, may be subject to an additional 10% penalty tax if the policyholder is under the age of 59 ½. This penalty applies to the portion of the distribution that is included in gross income.