I have a variable universal life insurance policy that my mom set up for me when I was a kid. Right now, it’s worth around $34,000 if I cash it out (the payout if I died would be $90,000).
Things have changed a lot since my mom set it up, and now if we put more money into it, it will become a ‘modified endowment’ policy or something like that. I’m about to have a baby, we need a better car (our ‘05 Accord is barely hanging on), and I have some credit card debt. So I’m considering cashing this policy out.
The plan would be to pay off the credit card debt, buy a newer used car, start a 529 college fund for the baby, and create an emergency fund.
The company holding the policy told me the taxable part of the $34,000 is actually $28,000. They said federal tax on it would be around 10%, which doesn’t sound too bad.
But I’m confused about state tax. I live in Chicago, IL. When I checked, it said IL state income tax is 4.95%, but then I saw that our household income (around $200k) is taxed at 24%. I just started my high-paying job recently, which is why my debts aren’t cleared up yet. I’m trying to be careful with money.
If the state is really going to take 24% of this lump sum, that might make me rethink cashing it out. I do have life insurance through work, and I plan to get a separate policy next year to make sure my family is covered.
Does anyone know how the IL state tax will work if I cash this in? Thanks!
You need to get some more details. If the cash value is $34,000, not all of that may be taxable. You’d need to know how much has been paid in premiums. Any amount that’s a return of the premiums paid is usually tax-free. I’ve had doubts before about life insurance companies claiming high taxable amounts. Sometimes the cash-out could end up being tax-free if the premiums match or exceed the cash-out value. Some policies like this can end up costing people more than they’re worth.
@West
Thanks a lot! This is a ‘Universal Variable’ policy. I’m not sure what that means, but here’s their website: Life Insurance | Thrivent
My mom originally set it up so I’d have money for college or other big expenses. I don’t think it’s like Whole Life or Term Life. I think the idea was always to be able to cash it out.
I’ll call them again and ask more questions. Thanks for the help!
The numbers you got don’t seem right to me. If $34,000 is the cash value and $28,000 is taxable, they’re saying only $6,000 was paid in premiums. I’d double-check this. I find it hard to believe $6,000 would grow to $34,000, though I guess it’s possible. You’ll want to confirm the actual numbers. The taxable part is treated as regular income, not capital gains. That means federal tax would be at your regular rate, not 10%, and the same goes for state tax. It might be best to have someone who knows taxes run the numbers and see the real impact.
Bao said: @Lior
I’m trying to find a local CPA to get some help on this. Thanks for the advice!
One way to do it yourself is by using FreeTaxUSA. Enter your info for 2023, save it, then do a version with the $28,000 added as ordinary income and see the difference. It’ll be close to what you’d pay next year.