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The designed solution is to pay premiums in excess of the actual cost of insurance (net cost of pure insurance) in your early years, so that can be invested (the cash value) and used to help pay for the actual cost of insurance in later years.
Calculating the taxable portion of your cash surrender value
To calculate the taxable amount, you first have figure out the ACB of your cash value. And it is unlikely you will have the information on hand. You will need to contact your insurance provider to get it. The good news: You don’t have to calculate the ACB, because the insurance company will do that for you.
However, there could be a problem with the insurance company providing you the ACB. Not that it will be wrong, but you may question it if you don’t understand how it’s calculated.
In your case, Rasheed, you paid $28,000 in premiums and the total cost of the “net cost of pure insurance” was $30,000. Now, rather than having an ACB of minus $2,000, the ACB is set at $0.
When you apply the taxable gain formula (CSV minus – ACB), the amount taxable is $27,000 minus $0. And you get $27,000. That amount is taxable, and it is not considered a capital gain.
In general, after 20 years, about half of the cash value of a whole life policy will be taxable. And after 40 years the total cash value will be taxable.
Surprised by T5
Rasheed, you are not the only one that’s been caught off guard by this type of tax notice. And it not only occurs when a policy is cancelled. You will also pay tax if you borrow from the policy in excess of the ACB.
My final tip: Always, always call the insurance company or your advisor to find the taxable amount before cancelling or borrowing from a whole life policy. And, yes, there can even be tax on the amount you borrow from the cash value.
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