When surrendering a life insurance policy for its cash value, which portion is taxable?

When surrendering a life insurance policy for its cash value, which portion is taxable?

• A. The entire cash value
• B. The gain (cash value minus cost basis)
• C. The premiums paid
• D. The death benefit

Answer: (B)

When you surrender a life insurance policy for its cash value, only the amount that represents a gain is taxable. The policy’s cash value grows tax-deferred, so you’ve already paid for the money with after-tax premiums, and the portion representing earnings is the part you owe taxes on. The gain is calculated as cash value minus the cost basis, where the cost basis is the total premiums you’ve paid into the policy. That gain is taxed as ordinary income in the year you surrender. For example, if you’ve paid $40,000 in premiums and surrender for $60,000, the taxable amount is $20,000. The remaining $40,000 isn’t taxed because it’s your return of the money you invested. The death benefit, if paid later to beneficiaries, is generally income-free. If the surrender value is less than the premiums paid, there’s typically no tax on a loss, and premiums aren’t deductible. Also, any outstanding policy loans reduce the surrender value but don’t change the rule: the taxable amount is the gain above your cost basis.

When you surrender a life insurance policy for its cash value, only the amount that represents a gain is taxable. The policy’s cash value grows tax-deferred, so you’ve already paid for the money with after-tax premiums, and the portion representing earnings is the part you owe taxes on. The gain is calculated as cash value minus the cost basis, where the cost basis is the total premiums you’ve paid into the policy. That gain is taxed as ordinary income in the year you surrender.

For example, if you’ve paid $40,000 in premiums and surrender for $60,000, the taxable amount is $20,000. The remaining $40,000 isn’t taxed because it’s your return of the money you invested. The death benefit, if paid later to beneficiaries, is generally income-free. If the surrender value is less than the premiums paid, there’s typically no tax on a loss, and premiums aren’t deductible. Also, any outstanding policy loans reduce the surrender value but don’t change the rule: the taxable amount is the gain above your cost basis.