What Tax Does Cashing Out a Life Insurance Policy Trigger?
When you surrender a life insurance policy for its cash value, the IRS treats the proceeds as taxable income. The tax applies only to the portion that exceeds the total amount of premiums you have paid, called the "cost basis." The remaining cash value that equals or is less than the premiums paid is tax‑free.
More from this site
Keep reading the latest coverage
Calculating the Taxable Amount
To determine the taxable portion, subtract the cumulative premiums paid from the total cash value received. For example, if you paid $50,000 in premiums and surrender a policy for $80,000, the taxable amount is $30,000.
Example Breakdown
| Item | Amount |
|---|---|
| Total cash value received | $80,000 |
| Total premiums paid | $50,000 |
| Taxable amount | $30,000 |
Tax Rates That May Apply
The taxable amount is added to your ordinary income for the year. It is then taxed at your marginal federal income tax rate, which ranges from 10% to 37% depending on your filing status and total income. State taxes may also apply, varying by jurisdiction.
Avoiding or Reducing Tax Exposure
Use a policy with a lower cost basis: Policies that charge high premiums relative to cash value grow more slowly, keeping the taxable portion lower.
Withdraw in small increments: Surrendering the policy in multiple years can spread the taxable income across tax years, potentially keeping you in a lower bracket.
Apply the 1035 exchange: Instead of cashing out, exchange the policy for another insurance product. This defers taxes until the new policy is surrendered.
Consult a tax advisor: Complex situations, such as policies with loans or partial surrenders, may require professional guidance.
Other Tax Considerations
Premiums paid with after‑tax dollars are not deductible, but the policy's cash value grows tax‑deferred. If the policy has been in force for many years, the cost basis may be close to the total cash value, resulting in little or no taxable gain. Conversely, early surrenders often generate significant taxable income.