Failed Life Insurance Policies Could Result in Substantial Tax Bill

Posted on January 27th, 2014 at 9:10 AM

From the Desk of Jim Eccleston at Eccleston Law Offices:

The failure of a life insurance policy could leave a heavy tax bill for the policyholders. 

The low interest rates nowadays make it hard for insurers to cover the policy’s cost so thatpolicyholders now are expected to spend more money keeping the insurance policy active, or to surrender the policy which means to cut death benefits or to try to sell the policy on the secondary market.

The threat behind failed policies is substantial. If the clients surrender the insurance coverage or let it lapse, and there were loans against the cash value, they could face a heavy tax bill for so called “phantom income.”

Even though the client stops paying the premiums, the costs will be deducted from the cash value automatically by many insurance policies. Those deductions are considered an internal loan, which could cause clients to lose the policy and to be in debt to the IRS.

So-called phantom income in the context of a life insurance policy can be activated in two ways. In the event of a surrender, phantom income is the difference between the money that the insurer pays to the client at surrender and the amount the client invested into the contract. In case of a lapse, where the client just stops paying premiums, the phantom income is the difference between the policy loan and the premiums paid into the policy.

There are few ways to avoid this situation once a client lapses or surrenders the policy without holding the taxable-income bag. One possibility is to negotiate a deal with the insurance company to reduce the face amount of the policy so that the policy costs less to maintain. 

The attorneys of Eccleston Law Offices represent investors and advisers nationwide in securities and employment matters. Our attorneys draw on a combined experience of nearly 50 years in delivering the highest quality legal services. 

Related Attorneys: James J. Eccleston

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