# How to Calculate Taxable Income When Cashing Out Life Insurance Pre-Death

As you pay your premiums as part of a life insurance policy, you are gradually increasing the size of what is commonly referred to as the "cash-surrender" value of your policy. In the event that you decide it is in your best interest to cash out your life insurance policy during your lifetime, this cash-surrender value will represent the amount of money you will be eligible to receive. That being said, opting to take the cash-surrender value of a life insurance policy comes with its own fair share of tax repercussions.

Calculating the amount of tax you will owe on your policy if you do choose to take the cash-surrender value will allow you to plan appropriately for this significant financial decision. Fortunately, the steps to determining the tax you will owe after cashing in a life insurance policy are relatively straightforward.

### Tip

In order to determine how much tax you will owe on your life insurance policy, you must determine the difference between the basis of the policy and its current cash-surrender value. This difference will be the profit you have earned, which will then be subject to taxation.

As stated previously, the cash-surrender value of a life insurance policy is the amount of money you will receive if you decide to redeem your policy for cash prior to your death. As you continue to pay premiums on your policy, the cash-surrender value will increase steadily. In order to determine how much tax you will pay when you opt to take your cash-surrender value, you must first determine the total sum of premiums that you have paid into the policy over its lifetime, less any prior withdrawals.

So, for example, if you have paid \$4,000 worth of premiums into the policy and taken two prior withdrawals worth a total of \$375, the current amount of funds invested in the policy would be:

\$4,000-\$375 = \$3,625

This value is referred to as the "basis." The basis will play a significant role when you begin the process of calculating the amount of profit you stand to earn when cashing out life insurance before death.

## Exploring Basis vs. Profit

After establishing the basis value of your policy, you will need to identify the current cash-surrender value. You can consult with your life insurance provider to determine what the current cash-surrender value of your policy will be. With this sum in mind, you can subtract the basis you calculated earlier to identify the exact amount of profit you will earn in the event that you complete the cashing out process.

It is critical that you take the time to incorporate any and all withdrawals or dividends received from the policy prior to cashing out, as this information can significantly affect the total amount of tax you will end up paying on the money you receive. As could be expected, the less profit you earn from your policy, the less tax you can expect to pay.

In the event that your basis is larger than the cash-surrender value of the policy, you will still receive the cash-out amount but will not be required to pay any tax on these funds. This is due to to the fact that you have technically earned no profit from cashing out the policy.

## Determining Total Tax Obligations

Now that you assessed the total amount of profit you will earn from the cash-out, you can accurately assess the specific amount of tax you will be required to pay. The funds you receive from the cash surrender value are taxable as ordinary income rather than capital gains. This means that these funds will be subjected to federal income tax regulations as well as any state-level income tax policies.

When it comes time to report this income on your tax return, you will use the standard IRS Form 1040 and list the profit from your policy as "other income." Keep in mind that this profit must be reported on Form 1040 during tax filing. Failure to do so can result in a variety of penalties and fines from the IRS.

Once you have committed to your cash out, your life insurance provider will provide you with a 1099-R that lists the gross payout from your policy following the cash-out. This information can act as an official point of reference once you begin filing your tax documentation.