J.K. Lasser's Your Income Tax 2013: For Preparing Your 2012 Tax Return

11.20 Selling or Surrendering Life Insurance Policy

Surrendering or selling a life insurance policy results in ordinary income, long-term gain, or a combination of both, depending on the type of policy and type of transaction. In Revenue Ruling 2009-13, the IRS presents three situations that illustrate the tax consequences of selling or surrendering a whole life or term insurance contract.

Situation 1 - surrender of whole life insurance contract.

On January 1 of Year 1, Tom Taxpayer bought a whole life insurance policy on his life, with the proceeds payable to a family member. Tom retained the right to change the beneficiary, take out a policy loan, or surrender the contract for its cash surrender value.

After 89½ months, on June 15 of Year 8, Tom surrenders the contract for its cash surrender value of $78,000. As of the surrender date, Tom had paid total premiums of $64,000, $10,000 of which was the cost of the insurance protection received as of that date. The $78,000 cash surrender value reflected the subtraction of the $10,000 insurance cost.

On the surrender, Tom recognizes income of $14,000, the $78,000 received minus the total premiums paid of $64,000.

The Tax Code does not specify whether income recognized upon the surrender of a life insurance contract, as opposed to a sale, is treated as ordinary income or as capital gain. However, relying on a 1964 ruling (Revenue Ruling 64-51), the IRS holds that the proceeds received by an insured upon the surrender of a life insurance ...