Texas General Lines — Life, Accident, Health and HMOLife InsuranceEasy
A 35-year-old individual purchases a $250,000 Whole Life insurance policy. After 5 years, the policy has accumulated a cash value of $15,000. If the policyowner decides to surrender the policy for its cash value, what is the tax implication if they paid $12,000 in total premiums?
- AThe $12,000 in premiums paid is tax-deductible.
- BThe $250,000 death benefit is taxable upon surrender.
- CThe $3,000 gain is taxable as ordinary income.
- DThe entire $15,000 cash value is taxable as ordinary income.
Show answer & explanationAnswer & explanation
Correct answer: C. The $3,000 gain is taxable as ordinary income.
When a life insurance policy is surrendered for its cash value, only the gain (cash value minus premiums paid) is subject to taxation as ordinary income. The premiums paid are generally not tax-deductible.
Why the other options are wrong
- A. Life insurance premiums are generally not tax-deductible, with some exceptions not applicable here.
- B. The death benefit is not relevant when surrendering a policy for its cash value; it is typically tax-free when paid to beneficiaries.
- D. Only the amount exceeding the premiums paid (the gain) is taxable, not the entire cash value.
Cash Value Surrender Taxation
When a whole life insurance policy is surrendered for its cash value, any amount received that exceeds the total premiums paid is considered a taxable gain.
- Only the gain is taxable, not the entire cash value.
- Taxable as ordinary income.
- Premiums paid are generally not tax-deductible.
Memory trick: Surrendering cash value means you only pay tax on the 'profit' you made.