Texas General Lines — Life, Accident, Health and HMOLife InsuranceMedium
A client purchased a $500,000 Whole Life insurance policy 15 years ago. The policy has accumulated $75,000 in cash value. The client decides to surrender the policy. What is the tax implication regarding the cash value received?
- AThe cash value is received tax-free because it is a life insurance policy.
- BThe entire $75,000 is taxable as ordinary income.
- COnly the amount exceeding the premiums paid is taxable as ordinary income.
- DThe cash value is taxed as a capital gain.
Show answer & explanationAnswer & explanation
Correct answer: C. Only the amount exceeding the premiums paid is taxable as ordinary income.
When a life insurance policy is surrendered, the cash value received is taxable only to the extent that it exceeds the total premiums paid into the policy. This is known as the Cost Basis Rule. The gain is taxed as ordinary income, not capital gains.
Why the other options are wrong
- A. This is incorrect; while death benefits are generally tax-free, cash value surrender proceeds are taxable if there is a gain.
- B. This is incorrect; only the gain over the cost basis is taxable.
- D. This is incorrect; gains from life insurance cash value are taxed as ordinary income, not capital gains.
Cash Value Surrender Taxation
When a life insurance policy is surrendered, any cash value received in excess of the premiums paid (cost basis) is taxable as ordinary income.
- Only the gain is taxable.
- Gain is calculated as cash value received minus total premiums paid.
- Taxed as ordinary income, not capital gains.
Memory trick: Cash in, cash out, what's left is taxed about.