Life Insurance✓ Verified · outline & fact-checked · Sep 2026Difficulty 2/5
A policyowner surrenders a whole life policy and receives its cash value. For federal income tax purposes, the portion of the cash value that exceeds the total premiums the policyowner paid (the cost basis) is:
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Answer & full 3-part explanation (select an option above, or peek)
Why A is correct
When a life insurance policy is surrendered, the policyowner recognizes taxable income equal to the cash value received minus the cost basis (total premiums paid, less any dividends or withdrawals). The taxable gain is ordinary income under IRC Section 72(e), not capital gain, because the policy is not a capital asset in the usual sense. This is part of the taxation of life insurance cash values under objective LIFE-II.F.1.
Why the other options are wrong
- B) Only the amount up to the cost basis is returned tax free; the gain over basis is taxable.
- C) The gain on surrender is ordinary income, not long-term capital gain, regardless of holding period.
- D) There is no 10-year rule that makes surrender gains tax free; taxation depends on the gain over basis.
Memory hook
Surrender gain = cash value minus premiums paid = ordinary taxable income.