A policyowner paid total premiums of $40,000 into a life insurance policy and surrenders it for a cash value of $75,000. What amount is taxable as ordinary income for federal tax purposes?

Why D is correct

On surrender, the policyowner recovers the cost basis of $40,000 tax-free, and the excess of the cash surrender value over basis is taxable as ordinary income under IRC §72(e). Here the excess is $75,000 − $40,000 = $35,000. That $35,000 is includable in gross income because the policy is not a MEC and the transaction is a full surrender, so the entire gain is recognized at once. The basis represents the after-tax dollars the owner contributed, and it is never taxed a second time when returned.

Why the other options are wrong

• A) $75,000 would tax the entire cash value and wrongly ignore the tax-free recovery of the $40,000 basis that the owner is entitled to receive first. The owner keeps the basis tax-free.
• B) $40,000 is the cost basis, which is recovered tax-free on surrender; it is not the taxable amount in this transaction. The taxable amount is the excess. The gain is what is taxed.
• C) $0 would be correct only if the cash value were less than or equal to the basis; here the cash value exceeds basis by $35,000, which is taxable. So a gain must be reported.

Memory hook

Surrender math: $75k out minus $40k in = $35k taxable gain.