Is Cashing In a Life Insurance Policy Taxable?

Permanent life insurance policies feature a cash value component that accumulates funds over time, which policyholders can access during their lifetime. While this provides liquidity, accessing these funds before the policy pays a death benefit can trigger a taxable event under specific circumstances. Understanding the tax implications is part of managing the financial outcomes of such a decision.

Determining Your Policy’s Cost Basis

To determine if money you receive from your life insurance policy is taxable, you must first calculate your cost basis. This figure represents your total investment in the policy for tax purposes and is the benchmark against which distributions are measured. Your cost basis is the sum of all premiums you have paid, minus any amounts previously received from the policy tax-free. These reductions include dividends paid out by the insurer or prior withdrawals that were considered a return of your premium payments. For example, if you have paid $50,000 in total premiums and received $5,000 in policy dividends, your cost basis is $45,000.

Tax Rules for Surrendering a Policy

When you surrender a life insurance policy, you terminate the contract with the insurance company in exchange for its cash surrender value. This action can result in taxable income if the amount you receive exceeds your policy’s cost basis. The cash surrender value is the accumulated cash value minus any surrender charges or outstanding loan balances.

The formula to determine the taxable amount is the cash surrender value you receive minus your cost basis. For instance, if your policy’s cash surrender value is $70,000 and your cost basis is $55,000, you have a taxable gain of $15,000. This gain is treated as ordinary income and taxed at your regular income tax rate, because the earnings within a life insurance policy grow on a tax-deferred basis. When you surrender the policy, the portion of the payout representing your premium payments is returned tax-free, while the earnings portion is subject to tax.

Tax Implications of Selling a Policy

Instead of surrendering a policy, you may sell it to a third party in a life settlement, which can yield a higher payout than the cash surrender value. The tax implications of a life settlement are more complex and use a three-tiered system for the proceeds.

The first tier is a tax-free return of your investment. The portion of the sale price equal to your cost basis in the policy is not taxed. For example, if you sell your policy for $100,000 and your cost basis is $60,000, the first $60,000 is a tax-free return of principal.

The second tier is the amount of gain treated as ordinary income. This is calculated as the difference between the policy’s cash surrender value and your cost basis. Continuing the example, if the cash surrender value was $85,000, you would subtract your $60,000 cost basis, resulting in $25,000 of gain taxed as ordinary income.

The final tier applies to any remaining proceeds and is treated as a long-term capital gain. This is the portion of the sale price that exceeds the policy’s cash surrender value. In our example, the difference between the $100,000 sale price and the $85,000 cash value is $15,000, which is taxed at long-term capital gains rates.

If the policyholder is terminally or chronically ill, the transaction may qualify as a viatical settlement. Proceeds from a qualified viatical settlement are typically received entirely tax-free. A policyholder is considered terminally ill if a physician certifies an illness expected to result in death within 24 months.

Tax Treatment of Policy Loans and Withdrawals

You can also access your policy’s cash value through loans or partial withdrawals. Taking a loan against your life insurance policy’s cash value is not a taxable event. The transaction is treated as a loan from the insurer, with the policy’s cash value serving as collateral.

The exception to this rule occurs if the policy is terminated or lapses while a loan is outstanding. If this happens, the outstanding loan balance, plus any accrued interest, is treated as a distribution. If this total amount exceeds your cost basis, the excess is considered taxable income, creating “phantom income” where you owe tax on money received in a prior year.

Partial withdrawals are treated differently. A distribution is considered a tax-free return of your cost basis first. You can withdraw amounts up to your total cost basis without tax liability. Once withdrawals exceed your cost basis, any additional amount is a distribution of the policy’s earnings and is taxed as ordinary income.

A significant exception applies if your policy is a Modified Endowment Contract (MEC), which has less favorable tax treatment. Distributions, including loans, are taxed on a “gains-first” basis, meaning earnings are withdrawn before the tax-free cost basis. For policyholders under 59½, the taxable portion of a distribution from a MEC may also be subject to a 10% penalty.

Reporting to the IRS

You must report any taxable gain from your life insurance policy to the IRS. The reporting process is facilitated by specific tax forms from the insurance company or life settlement provider.

If you surrender your policy, you will receive Form 1099-R. This form shows the gross distribution amount and indicates the taxable portion. You will use this information to report the taxable amount as ordinary income on your tax return.

For a life settlement, you will receive two tax forms. The buyer issues Form 1099-LS, which reports the gross proceeds paid to you. The life insurance company provides Form 1099-SB, which reports your cost basis. You will need both forms to calculate and report the ordinary income and capital gain components of your gain.