Question: Are withdrawals from a cash value life insurance policy ever tax free?
 
Answer :
First of all, certain types of cash value life insurance policies (e.g., universal and traditional whole life policies) may not allow you to withdraw from your cash value at all. If your policy does allow such withdrawals, 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.

But keep in mind that your policy's cash value consists of your basis in the policy, plus any earnings. Because the earnings grow tax deferred while inside the policy, they will be subject to income tax when you withdraw them. This means that if you make a withdrawal over and above your basis in the policy, a portion of the withdrawal will be considered taxable income. Withdrawals are generally treated as coming out of your policy basis first.

For example, you have a cash value life insurance policy with a cash value of $18,000. Your basis in the policy is $12,000. If you make a withdrawal of $12,000 or less, there will be no income tax consequences. However, if you withdraw $15,000 from the policy, you'll have to pay income tax on $3,000 of it (at ordinary income rates, not at capital gains rates).

Be aware that surrender charges may also apply when you withdraw from your policy, even if you withdraw only up to your basis. One way to avoid this and still access your money is to take a policy loan from the insurance company, using the cash value in the policy as collateral. The amount you borrow is generally not treated as taxable income as long as you repay the loan, and there are no surrender charges because you're not actually withdrawing your money. But you'll have to pay interest on the loan, which is not tax deductible.