A policyowner surrenders a life insurance policy for its cash value of $25,000 after having paid $20,000 in premiums. For federal income tax purposes, the $5,000 excess:

Why C is correct

On surrender of a life insurance policy, the policyowner compares the cash received to the cost basis, generally the total premiums paid. The amount received in excess of the basis is taxable as ordinary income under IRC Section 72(e), because it represents the inside build-up of cash value that had grown tax-deferred. In this example, $25,000 received minus $20,000 of premiums leaves a $5,000 taxable gain. If the amount received were less than the basis, no taxable gain would arise.

Why the other options are wrong

• A) Tax deferral is not tax exemption; the gain realized on surrender is income, even though death proceeds are tax-free.
• B) There is no rule taxing surrender gain only if death follows within three years; the gain is taxed whenever the policy is surrendered.
• D) The gain on a life insurance surrender is ordinary income, not capital gain, and is not eligible for preferential capital gain rates.

Memory hook

Take out more than you put in — the profit is ordinary taxable income.