When a policyowner surrenders a life insurance policy for its cash surrender value, the amount subject to federal income tax is:
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Answer & full 3-part explanation (select an option above, or peek)
Why A is correct
On surrender, the policyowner realizes the cash surrender value. Under IRC §72(e), the taxable amount is the excess of the amount received over the policyowner's cost basis (investment in the contract, generally the premiums paid). The basis is recovered tax-free and only the gain — the difference between what was paid in and what came out — is taxable as ordinary income. If the cash value is less than the basis, no taxable gain results. The same rule applies to full surrenders regardless of whether the policy had paid dividends, and dividends previously received reduce the basis.
Why the other options are wrong
- B) The full cash value is not taxable; the policyowner recovers the cost basis first, and only the gain above basis is taxed as ordinary income. The basis is returned free of tax.
- C) There is no special one-half rule for surrender; the tax is based on the actual excess of the amount received over the cost basis. The whole gain is what counts.
- D) Accumulated dividends are not the measure of gain; gain is the full excess of proceeds received over the total cost basis, not the dividend balance. Dividends only reduce the basis.
Memory hook
Surrender tax = cash out minus cash in (premiums paid); only the profit is taxed.