Tax Consequences of Surrendering a Life Insurance Policy

Estimated reading time: 10 minutes

It often surprises people that surrendering their life insurance policy has tax consequences! Don’t worry. This doesn’t happen in every case.

This article explains what triggers the possible tax burden, how it’s calculated, the role of cash value accumulation, different types of policies, and how surrender fees and outstanding policy loans impact the taxes you may owe.

As always, when reading financial information on the internet, consult with your tax advisor for information for your specific situation. We do not provide tax advice.

Definition of Surrendering a Life Insurance Policy

Surrendering your life insurance contract means that you’re terminating the policy. You don’t want or need it anymore, so it’s gone. Or, maybe you want the cash value built up in the contract. Either way, you’re washing your hands of it.

This option usually applies to permanent life insurance policies, such as a whole life policy or universal life. Permanent life insurance typically accumulates cash value over time, which factors into the surrender value.

When you, the policyholder, surrender your policy, you’re essentially canceling your policy to get the cash surrender value. However, surrendering your policy is not the only way to get the cash surrender value. You might also consider a policy loan or a partial surrender.

How Much is Your Life Insurance Policy Worth?

If you want to get rid of your policy entirely, you may get more money by selling your policy rather than surrendering it. Use the form below to see what you might be able to get for selling your life insurance.

Overview of Potential Tax Implications

Surrendering a life insurance policy may trigger tax consequences, AKA a surprise tax bill. This trigger primarily depends on the following:

• Policy type
• Cash value of the policy
• Total amount of premium

The IRS (Internal Revenue Service) considers the surrender of a life insurance policy a taxable event if the surrender value is more than the premiums you’ve paid. Getting a handle on these numbers and understanding the math will be key to getting the best tax outcomes – along with talking with your tax advisor before you surrender the policy.

Before we dive into the cash value factors, there is one major note you should be aware of as far as policy types.

Term life insurance does not carry any cash value, which means that there’s no surrender value to the contract. If you cancel the policy, you won’t get anything back. It’s just over. If you do need cash from your term policy, you may be able to sell your term life insurance instead.

Cash value policies (whole life, indexed universal life, etc.) do build cash value and may trigger these taxes when canceled or surrendered.

Understanding Cash Value Life Insurance Policies

A cash-value life insurance policy has both benefit coverage that lasts for your lifetime and a cash-value component that grows on its own. Part of the premiums you pay for permanent life insurance goes toward building the cash value. It accrues interest or grows through investment returns, depending on the type.

A whole life insurance policy is the most common type of permanent insurance. Its cash value typically grows at a fixed interest or dividend rate but remains focused on the life insurance payout to beneficiaries.

We tend to recommend indexed universal life for cash value building purposes. It offers more flexibility in that you can adjust your premium and death benefit while the policy is in force. It also ties the cash value account growth to a stock market index, such as the S&P 500.

Explanation of Cash Value Accumulation in a Life Insurance Policy

It takes a while before the cash value in your life insurance becomes useful, often as long as ten years.

Officially, the cash value grows tax deferred. If the policy matures while you’re alive, the insurance company will pay out the benefits, and you’ll owe taxes. You’ll owe taxes if you cash out the policy through a surrender or partial withdrawal.

However, if you want to take advantage of the cash value while you’re still alive, you can use policy loans. These loans let you borrow from your life insurance (using the death benefit as collateral), and you can do whatever you want with the cash. You don’t even have to pay it back.

We’ve seen people use their policy’s cash value for everything from buying a new car, vacation, down payment on a home, financing a child’s college education, and even a tax-free retirement income stream.

Differences Between Surrendering a Term Insurance Policy & a Cash Value Policy

Term life insurance coverage does not accumulate cash value, as said before. It also has a limited number of years before expiring. Surrendering a term policy just means you cancel it. There are neither financial returns nor tax consequences for you. They are straightforward contracts. You may be able to sell your term policy if it has a conversion feature.

If you want to see if selling your term life policy makes sense, click here for more on that topic.

Cash value policies are more complex. Surrendering a cash value policy may provide you with the accumulated cash value, which can be taxable minus any surrender charges. However, to trigger the tax charges, the cash value must be more than the amount of money you paid in premiums for the policy.

Income Tax Consequences of Surrendering a Life Insurance Policy

When surrendering a cash value life insurance policy, you may get more back than the entirety of what you spent on premium payments.

The IRS considers the difference as taxable income. What amount you’ll owe in taxes depends on your marginal tax rate for the year, often called your income tax bracket.

In short, you might owe the IRS a big percentage of your surrender value, particularly if you’re a high-income individual or family. Plan accordingly! Consult with your tax attorney or financial advisor for the specific tax implications and get some ideas to minimize some of the tax burden.

Ordinary Income vs. Capital Gains Taxes

Cash from surrendering your life insurance is taxed as ordinary income, as opposed to capital gains. Ordinary income (wages, salaries, and other forms of income) is taxed at the Federal level between 10% and 37%, depending on your income level.

It’s an important point because income taxes are typically higher than capital gains tax rates, meaning you’ll likely owe more in taxes. And, if it was a large cash value policy, it may even bump you up a tax bracket.

The IRS defines capital gains as profits from the sale of assets held for investment purposes, think stock or real estate. Long-term capital gains rates vary, again depending on income, between 0% and 20%.

Taxable Gain Calculation for Surrendered Policies

The taxable amount, subject to ordinary income tax, is the difference between the cash surrender value minus the total premiums paid. You can find this information on your latest policy statement or by contacting your insurance company. Accurate records for these numbers are essential for staying compliant with IRS taxation guidelines.

For example, if you have paid $50,000 in premiums over the life of your policy and the cash surrender value is $70,000, then the taxable gain when surrendering your policy would be $20,000. The percentage you’ll owe in taxes is whatever your current tax bracket is.

How Surrender Fees Affect the Taxable Amount

Surrender fees are extra charges that the insurance company deducts from your cash value component if you surrender the policy before a specified number of years, usually around ten. They’re also normally on a sliding scale, reducing over time. While each company is different, we often see surrender fees starting at 10% in Year 1, then reducing by 1% each year until dropping to 0% in Year 10.

Let’s go back to our example. If your cash value is $70,000, you paid $50,000, and your surrender fee is $5,000, it’ll look like this. The net surrender value (cash value – surrender fee) will be $65,000. To calculate the taxable gain, we then subtract the premiums paid ($50,000). That leaves you with $15,000 of taxable gain.

Deductibility of Surrender Charges

Since it comes up every once in a while, surrender fees are not deductible on the policyholder’s tax return.

The non-deductibility of surrender charges is important for proper tax planning. These charges reduce the amount you get from cashing out your policy, and they reduce the amount of taxable gain you might pay. But they don’t offer any extra tax relief. Bummer.

Treatment of Outstanding Loan Balance Upon Surrender

If you have an outstanding loan against your cash value, then the insurance company will repay itself loan amount and any interest from the cash surrender value when you begin that process.

In short, the surrender value would be the same, regardless of your loan.

Let’s go back to our example again.

If the cash surrender value on your policy is $70,000 and you have an outstanding loan balance of $10,000, the net surrender value would be $70,000. (You’re repaying the loan from the surrender value, but it still counts as taxable gain.) If you’ve paid $50,000 in premiums, then the taxable gain would still be $20,000. Note: there may be interest involved here, so definitely consult your tax advisor!

Should I Surrender My Life Insurance Policy?

It comes down to your financial goals. What do you want or need the cash for? Is there an advantage to maintaining the policy?

Understanding the tax consequences of surrendering a life insurance policy can shed light on your pros and cons list. Consider your current financial situation, future financial needs, and current levels of risk.

You also have alternative options. You could also:

• Borrow against the policy from the cash value
• Consider reduced paid-up insurance to free yourself of paying premiums
• Sell the policy, often for more than the cash surrender value

Frequently Asked Questions

Will I owe taxes if I surrender my life insurance policy?

It depends. The difference is considered taxable income if the total cash value you receive exceeds the amount you’ve paid in premiums. If your payout is less than or equal to your cost basis (the total amount you’ve paid in premiums), there are no taxes owed.

How do I calculate the taxable portion of my surrendered policy?

To determine how much is taxable, subtract the total amount you’ve paid in premiums from the cash surrender value. If the result is positive, that amount is considered taxable as ordinary income.

Will surrendering my policy affect my estate planning?

Yes, it could. If your policy was meant to provide financial support to your beneficiaries, surrendering it removes that protection. Additionally, the cash value received could increase your taxable estate, which may have implications depending on your total assets.

Are there penalties for surrendering my policy early?

Most permanent life insurance policies have surrender charges that decrease over time. If you surrender your policy within the first few years, you could face higher fees. These fees are deducted from your payout, so it’s important to check your policy terms before making a decision.

Can I access my policy’s cash value without surrendering it?

Yes. Depending on your policy, you may be able to take a loan against the cash value or make a partial withdrawal. These options allow you to access funds while keeping your policy in place. However, they may impact the death benefit and have tax implications if not managed properly.

What are my alternatives to surrendering my policy?

If you no longer need or want your policy, you might consider a life settlement, where you sell your policy to a third party for more than the surrender value. You could also explore converting your policy into an annuity or using it to fund long-term care expenses.

Should I talk to a financial professional before surrendering my policy?

Absolutely! Surrendering a life insurance policy is a major financial decision that can have tax consequences and impact your long-term financial security. Consulting with a financial advisor or insurance specialist can help you weigh all your options and make the best choice for your situation.

How Abrams Insurance Solutions Can Help

Selling a life insurance policy (AKA a life settlement) can put more cash in your wallet than surrendering your policy.

You can read more about how to get a larger cash payment for the sale of a life insurance policy here. Alternatively, use the form on this page to see how much your policy might sell for. We’ve found, in most cases, that it’s higher than the cash surrender value, especially if you’re looking at surrender fees.

Call us at (858) 703-6178 with any questions. Our team has experience helping people get the most cash for their policies and is happy to answer them.