Are Life Insurance Surrender Amounts Taxable?

In many ways, an insurance policy works like a savings account.

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Maybe your children are adults who support themselves and you’ve outgrown the need for life insurance or maybe you just need a quick injection of capital. Either way, canceling your life insurance policy, which is known as surrendering it, can be a small windfall. Understanding how much of its value will remain after the Internal Revenue Service takes its cut can be tricky, but it can be an important factor when you consider receiving the cash surrender amount.

Insurance Policy Basics

Unless you make premium payments that can be claimed as a tax deduction, which is somewhat rare, the money you pay your life insurance provider has already been taxed. If the premiums are paid post-tax, you’re never taxed on the amount you paid into the policy. If you made pretax premium payments, when you take possession of the cash surrender you deferred taxes on it, and you’ll owe regular income taxes on the amount.

Investment Income

While you pay into your policy, the insurance provider invests your premiums until your policy comes due or you choose to receive the cash surrender value. As your premium earns investment income, the provider shares a portion of that revenue with the policyholder. If your policy earned investment revenue, you receive it in addition to the premiums. Because this money is investment income and not merely a return on already-taxed premiums, the IRS taxes it..

Cash Surrender Tax Example

To determine the taxable portion of your cash surrender value, merely deduct the amount you paid in premiums from the total amount. For example, if you paid $100 monthly for 10 years, the amount of your premium is $12,000. If you surrender the policy and receive a cash value of $13,400, your insurer reports $1,400, or the cash value less the premiums, to the IRS as investment income. You’ll be taxed on this $1,400 as if it were interest.

Benefits and Taxes

Although you may owe income taxes if you choose to surrender your policy, policy payouts to a beneficiary are never taxable in the event of your death. However, if you name yourself as the beneficiary of the policy, the benefit doesn’t pass to your heirs directly, and instead becomes part of your estate. While this only impacts estates worth more than $5,120,000 as of 2012 -- this exemption may be lower if you used portions of it to avoid gift taxes – the benefit value will be taxed at estate tax rates before your heirs receive it.