Florida 2-15 Life, Health and Variable Annuity AgentGeneral Knowledge of Life InsuranceMedium
A policyowner has a $200,000 whole life policy and decides to surrender it for its cash value. The policy has accumulated $30,000 in cash value, and the policyowner has paid a total of $25,000 in premiums. What amount, if any, is taxable as ordinary income?
- A$25,000
- B$0
- C$30,000
- D$5,000
Show answer & explanationAnswer & explanation
Correct answer: D. $5,000
When a life insurance policy is surrendered, the amount taxable as ordinary income is the difference between the cash value received and the total premiums paid. In this case, $30,000 (cash value) - $25,000 (premiums paid) = $5,000 taxable income.
Why the other options are wrong
- A. Incorrect; this is the total premiums paid, which is the cost basis, not the taxable gain.
- B. Incorrect; there is a gain when cash value exceeds premiums paid.
- C. Incorrect; this is the total cash value, not the taxable gain.
Taxation of Cash Value Surrender
When a life insurance policy's cash value is surrendered, any amount received that exceeds the total premiums paid (cost basis) is considered taxable income.
- Cash value withdrawals up to cost basis are generally tax-free.
- Any amount received above the cost basis is taxed as ordinary income.
- Loans against cash value are generally not taxable.
- Death benefits are generally tax-free to beneficiaries.
Memory trick: Taxing life insurance depends on when and how money leaves the policy.