Taxes on Surrendered Life Insurance Policies

What happens when you cash in a life insurance policy? This process is called "surrendering" the policy. A life insurance policy surrender may trigger certain tax consequences that you'll need to know to avoid getting into trouble with the IRS. Before you surrender that policy, make sure you understand what will happen to you at tax season.


When you surrender a life insurance policy, you may be taxed on any gain inside of the policy. First, you will only have to worry about this if you own a cash value policy. A cash value policy is a permanent life insurance policy that builds a cash reserve along with a death benefit. The cash reserve is a literal savings that may be used for any purpose. The cash value receives certain tax benefits, like an exemption from income tax while the policy is in force. When you surrender the policy, you lose this exemption.


If you've lost money in your cash value policy, you won't worry about tax on the surrendered amount. A loss means that you have less money in your policy than you paid in premiums (in total). Penalties imposed by the insurance company, along with any fees charged by the contract, are not counted towards loss. Only investment loss, if applicable, may be considered when determining whether you've gained or lost money in the contract.


If you have more money in your policy than what you've contributed to it, then you have a gain. All money in excess of the total amount of premiums you've paid represents the amount of money that will be subject to taxation. Income tax is triggered as soon as you cash in the policy. The insurer must send you a 1099 form at the end of the year for the amount of gain you have realized.


Before you surrender your policy, consider keeping it. Even if you have realized a loss, you may be able to reallocate the premiums and cash value inside of the policy into different investments to recover your losses. If you own a whole life policy or a fixed interest universal life policy, then consider keeping the contract. With fixed interest policies, you normally should see a gain in your policy, even though it might take many years. If you cash in the policy during the surrender period listed in the contract, you may end up with much less than you expect due to the fees charged by the insurer for early termination.