Is the Cash Surrender Value of Life Insurance Taxable?

The taxability of life insurance cash surrender value causes much confusion.  Agents often extol the tax-free nature of life insurance.  But the marketing brochures often have numerous footnotes on the tax subject.

So is your cash surrender value of life insurance taxable?  The answer is yes.  The answer is also no.  The truth is, asking simply: “is my life insurance cash surrender value taxable?” isn't the right question.

The right question is: “when is the cash surrender value of life insurance taxable?”

General Rule: Cash Value Inside The Life Insurance Contract

As a general rule of thumb, when cash value remains inside a life insurance contract, it is not taxable.  This means that as cash value grows inside a life insurance policy, you will not owe taxes on the interest or dividends earned on this cash value.  The key feature is that everything remains inside the policy.

Cash Value Accumulation Deferred Taxes

Wendy owns a universal life insurance policy that earns $4,000 in interest this policy year.  Because the interest earnings remain inside the life insurance policy, Wendy will not owe taxes on the $4,000 interest earnings on her cash surrender value.

Notice that in the example above life insurance taxability is different from an ordinary savings account.  If Wendy earns $4,000 on her savings account this year, she will need to report the interest earnings as income when she files her taxes.  She will then owe ordinary income taxes on the $4,000 interest payment.

Because the interest earnings remain inside the life insurance policy, Wendy does not owe taxes on it.  Wendy can compound her cash surrender value growth through the interest payments and she will owe no taxes on the interest payments so long as the cash value remains in the policy.

Whole Life Insurance Dividend Example

Harold owns a whole life policy that earned $4,000 in dividends this policy year.  Harold chose to purchase paid-up additions with the dividend earnings.

Using the paid-up additions option with the dividend payment keeps the money inside the policy and Harold owes no taxes on the dividend payment.

When Money Leaves a Life Insurance Policy

There are two ways to take money out of a life insurance policy while it remains in force.  First, one can withdraw cash through a partial surrender.  Second, a policyholder can take a loan against the life insurance policy.  Let's explore the taxability of these actions.

Withdrawing Money from a Life Insurance Policy

Life insurance enjoys many tax-favorable treatments.  One beneficial tax treatment of life insurance is the First In First Out (FIFO) accounting principle.  FIFO allows the policyholder to recoup his/her contributions to the policy before he/she must remove gains from the policy.

FIFO Life Insurance Withdrawal Example

Emanuel owns a whole life insurance policy with $500,000 of cash surrender value.  He paid a total of $150,000 in premiums to date.  He wants to withdraw $50,000 from the policy.

The $50,000 is non-taxable to Emanuel because he is removing part of his contributions to the policy (the $150,000 he paid in premiums).

Because of the FIFO rule, life insurance policyholders can withdraw money from their policies up to the amount they put in and pay no taxes on the distribution.  This is because they are technically taking back the dollars they put into the policy.

The alternative to FIFO is Last in First Out (LIFO).  Under this accounting rule, the account holder must first remove any gain before he/she can remove contributions (also known as cost basis).  Using the example above, if Emanuel withdrew the money from an account that uses LIFO, he would owe taxes on the $50,000 distribution because the account currently has a $350,000 gain.

Luckily, all life insurance policies use FIFO accounting rules.

Withdrawing Money Beyond the Basis

Emanuel decides instead that he need to withdraw $200,000 from the policy.

Doing this, Emanuel will owe taxes on $50,000.  He owes no taxes on $150,000 of the withdrawal because that is his cost basis in the policy.  The $50,000 remaining is part of the gain he achieved with the policy and he'll owe ordinary income taxes on this sum.

Any amount withdrawn above the cost basis of a life insurance policy is taxable as ordinary income.  If Emanuel canceled the entire policy, he'd receive $500,000 in cash from the life insurance company.  He would also owe taxes on $350,000.

Using Life Insurance Policy Loans to Avoid Taxes

As I already mentioned, you can also use a life insurance policy loan to take money out of a policy.  Actually, a loan doesn't remove money from your policy.  What technically happens is a pledging of the money in the policy as collateral for a loan issued by the life insurance company to the policyholder.  The cash in the life insurance policy never leaves the policy.

Because the money never leaves the policy and because the IRS does not view loans as income (in most cases) the life insurance policy loan is a non-taxable event.  This is true even when generating a loan that goes beyond the cost basis of the policy.

Loan and Withdrawal Distribution

Instead of withdrawing all $200,000 from his policy, Emanuel's agent suggests he take a $150,000 withdrawal and a $50,000 loan to avoid tax liability.

Taking the distribution from the policy in this fashion completely avoids any taxability to Emanuel.  He withdraws his basis, which is nontaxable to him.  He then takes a loan for the remaining $50,000, which also has no taxability to him.

Life insurance policyholders can use loans on cash surrender value to avoid taxes without needing to withdraw any money.  From the example above, Emanuel could simply take a loan for $200,000 and he'd have no tax liability.  The decision to take a withdrawal versus a loan can be complex and we'll address it in more detail in another blog post.  I simply want to point out that one doesn't necessarily have to withdraw money up to his/her basis first before taking a policy loan.

Life Insurance Policy MUST Remain In Force to Avoid Taxes

If using a loan, you must understand that the tax-free nature of the loan only remains tax-free if the life insurance policy remains in force.  If you cancel a life insurance policy with an outstanding loan, you will owe taxes on any gain on the policy.

Canceled Policy with Outstanding Loan

Emanuel has a whole life policy with $500,000 of gross cash value.  He paid a total of $150,000 in premiums to the policy.  He also has a $200,000 outstanding policy loan.  He decides to cancel his life insurance policy.

Emanuel receives $300,000 in cash from the life insurance company.  This is his cash surrender value after repaying the loan.  He will owe taxes on $350,000 because of the $50,000 he already distributed from the policy through a policy loan.  [/thrive_text_block]

It is possible, though not very common, to cancel or lapse a life insurance policy with significant outstanding policy loans.  In this situation, the taxes due may far exceed any remaining cash value received upon policy termination.  For this reason, policyholders should take some cautions to ensure canceling a policy will not cause substantial tax liability due to outstanding loans on the policy.

It's also important to know that if the policyholder dies, the taxability of the distributions through policy loans goes away.  Because the policy ended up paying a death benefit, there is no tax liability on the outstanding policy loans.  The insurance company will use a portion of the non-taxable death benefit to pay the outstanding policy loans and the remaining death benefit will go to the beneficiary(ies).

Example of Death when Loans Outstanding

Emanuel owns a whole life policy with gross cash value of $500,000.  He paid $150,000 in premiums to the policy.  He has outstanding loans totaling $200,000.  The policy has a $1 million death benefit.  Emanuel passes away.

The Insurance company will pay off his outstanding $200,000 loan with a portion of the $1 million death benefit.  The remaining death benefit amount of $800,000 will go to his beneficiary(ies).  There is no tax owed either by Emanuel or his beneficiary(ies) despite the outstanding loan that distributed $50,000 of his policy's gain.

Cash Surrender Value and the 1035 Exchange

There are times when people wish to buy new life insurance.  There are also times when people wish to buy new life insurance and transfer the cash surrender value of their old policy into this new policy.  Thankfully, tax law does allow for a very tax-efficient mechanism to accomplish this.

The 1035 exchange allows a life insurance policyholder to transfer the cash surrender value of his/her policy into a new life insurance or annuity policy without owing any taxes on the gain of the policy.

If the 1035 exchange didn't exist in U.S. Tax Code, then anyone wishing to buy a new policy and moving cash in his/her old policy to the new policy would need to:

  1. Surrender the old policy
  2. Use the cash received by policy surrender to pay premiums on the new policy
  3. Report the gain from the cash received by the old policy surrender as income
  4. Pay taxes on the gain from the old policy

Luckily none of this is necessary, as policyholders can simply move the money from an old policy to a new one through the 1035 exchange.  Policyholders can also transfer their cost basis from the old policy to the new policy.  This might have strategic tax benefits.

But you shouldn't assume that just because you have cash surrender value in your old policy, you have to use a 1035 exchange when buying a new policy.

If the old policy has no gain, then the 1035 exchange's tax-free transfer feature is moot.  You wouldn't owe taxes when canceling your old policy because you've paid more in premiums than you have in cash surrender value.

The Above Information Applies to Life Insurance Specifically

I want to point out that the examples above specifically speak to life insurance.  If you have a policy that violated the Modified Endowment Contract Test then you have a contract with very different rules concerning the taxability cash surrender value.

60 thoughts on “Is the Cash Surrender Value of Life Insurance Taxable?”

  1. Hi Brandon,
    Excellent information. Since, we’re on the point of life insurance and income taxation….what are your thoughts on an individual borrowing against their cash value (in a whole life policy) and using the loan proceeds for a business purpose (let’s assume that the individual who personally owns the whole life policy has a separate LLC and needs additional capital for equipment acquistion), thus allowing the individual the opportunity to deduct on their 1040, the interest paid back to the life insurance company? Of course, all aspects of this transaction would be documented, just in case the IRS decides to ask for clarification.

    • Hi Todd,

      I think it’s a good example of how business owners can use life insurance and capitalize on U.S. Tax Code to further augment the benefits.

    • Hi Peni, gain is any cash value in excess of the premiums paid to the policy.

      So CV – P = G


      CV is cash value

      P is the sum of premiums paid

      G is the gain

  2. If Have a paid up whole life insurance policy, and I have paid up dividend to IRS annually do I still owe taxes on the cash value of the policy I take it?

    • Ask the insurance company what the cost basis is on the policy and compare it to the current cash value. If cash value is higher than cost basis, then a surrender of the contract will report taxable income in the amount of this difference. If you withdraw money from the contract, you can withdraw tax free up to the basis. If you take a loan, this will not be reportable income for tax purposes.

  3. Hi Brandon,
    Thanks for the excellent information you have provided. But my problem is one more step and I need your help.
    I had life insurance issued in 1997 and had been paying, from my after tax income, a premium of $2621.00 till Oct. 2019 (Total paid for 21 year $55o41.00.).In 2019 Oct. I surrendered the policy when it had a cash value of $39846.86. and got the cheque for that amount. For the tax returns I got T5 slip reporting the whole amount as other income. Financial adviser filing my income-tax returns says the whole amount is taxable.
    My questions is how and where do I claim the dividends I have paid if these are eligible for deduction. I have a net loss on the money I paid.
    Thanks in advance for the advicwe.
    Mohan Bains.

    • Hi Mohan,

      I’m going to guess based on this information that you are Canadian. We right this blog as an informational resource on U.S. life insurance and tax policy. We are not experts on Canadian life insurance tax laws. You’ll need to seek out someone who is more apprised on Canadian tax law regarding life insurance. Sorry we can’t be of further assistance.

    • Hi Janette,

      This depends a bit on what your relationship is with the person to whom you are transferring ownership of the policy.

  4. Hi,

    Fantastic article, very helpful. My mother recently found out that my father took a life insurance policy on her decades ago and never told her. Recently they got in touch with her because evidently the premium was being paid out of the cash value after my father stopped paying the premium years ago. They gave her the choice of either keeping the insurance if she caught up on the premiums or cashing out for the surrender value.

    Since she didn’t even know she had a insurance policy, she opted to just surrender it and take the cash out. The surrender value is $19000, but they said she would have to pay taxes on $45,000 in income that they would report they gave her. How could that be? We are both confused about that.

    • Hi Charlie,

      If your mother is the owner of the policy and loans paid the premiums for several years, it’s possible that the loan balance of the policy created this income that your mother would realize if she surrendered the policy.

      If she owns the policy (that’s very important here) should opt to pay down the loan of the policy and continue putting money in there. She’d benefit immensely from the rate of return on the cash value and her personal rate of return would most likely be great since she’s not the one who originally paid several premiums.

  5. Hi, Brandon,
    I need to cash out my policy, but I’ve paid more in premiums than the cash value. I just want to make sure that I would not be responsible for taxes on that cash value because I lost money?

    • Hi Brooke,

      Yes if your current sum of premiums paid is higher than the cash surrender value, then you should owe no taxes on the surrender. Do keep in mind that when I say sum of premiums, I’m assuming base policy premiums and PUA rider (if applicable). Some life insurance riders do not count towards your cost basis, so it’s prudent to check with the insurance company to determine your cost basis in the policy. Assuming the cost basis is still larger than the cash surrender value, you should not have a taxable distribution.

  6. Brandon, my question is similar to Brookes. I just cashed out a policy I’ve had since 1997 because it was costing me $30 per month for $15,000 coverage. I have another policy through my employer for $60,000 costing me about $15 per month so it didn’t make sense to me to carry both. So I would add all of the premiums paid since 1997 and if that is higher than the cash surrender value no taxes owed?

  7. Hello, if I’ve had a universal life insurance policy since 1993 and believe I’ve paid more premiums than the cash value of about $6,000. My income tax bracket is about 22%. Should I withhold 10% to be safe? If I do not withhold and end up having to pay taxes in the end, what happens? If I do withhold and it was unnecessary, do I get money back?

    • Hi Jen, If you withhold and end up not needing to this money will simply be refunded by the IRS when you file your taxes next year (assuming that you cancel the policy by the end of this year, otherwise you’ll get the refund in 2022).

      If you do not withhold and you end up owing money on this policy cancelation, then you’ll calculate that amount owed at tax time and either pay it when you file your taxes or the amount will be deducted from your tax refund (assuming your income tax withholdings/payments made throughout the year were more than your overall tax liability).

  8. Hi Brandon,

    If I cash out a life insurance policy after 30 years, when am I responsible for paying the federal and state taxes on the gains? I normally would file a 1040 for my previous income year by the April 15th deadline of the following year. Am I responsible for paying the insurance gains sooner than the next tax filing for the year the gains are received?

    Thanks, Steve

    • Hi Steve, taxes should be due when you file for the year in which you received the funds. So if you surrendered the policy in 2021, you would calculate the tax liability from the surrender as part of the tax return you officially file by April of 2022.

      Most insurers will provide you the option to have a portion of the surrender value withheld and sent to the IRS in anticipation of the taxes due. If they withhold too much, this becomes a downward adjustment (possibly part of a refund) on your tax liability when you file your taxes.

  9. My father took out an insurance policy for me when I was born (1957.) He has since passed away, and I surrendered the policy and received about $3,000. The insurance company did not issue a 1099-R as they said the contract was issued before August 13, 1982. I’m assuming I need to include this as taxable income; can I deduct the premiums paid even though I did not pay them myself?

  10. Hi Brandon, I hope you can help me with my question. I have a variable life insurance policy with John Hancock that I have paid 39,555.00 in premiums since 1990. The net cash surrender value is 105,607.30. My daughter is the beneficiary and she could use the money now versus the death benefit which is $164,000. Well cashing out create a taxable event and how much? Thanks, Michael

    • Hi Michael, the taxable income amount is the gross cash value minus your cost basis (essentially premiums paid). The exact amount of taxes you’ll owe depends on your other income. You’ll need to consult your tax return information or (if applicable) the tax professional who assists with preparing your tax return.

  11. I had to liquidate my brother’s
    Assests as he is in a nursing home and had to apply for assistance to pay the nursing home all proceeds were paid to the nursing home
    Are the proceeds taxable??

    • Hi Jean, we cannot answer your question given the limited amount of information you provided. You are should seek specific guidance from a tax professional regarding this.

  12. Hi Brandon. I’d started a life insurance in 2019 & can no longer afford to keep due to the pandemic situation. I unfortunately need to surrender & was told that I’ll lose my paid premiums. I just want to make sure that the withholding taxes do not apply here. Thanks!

  13. Hi Brandon, I just surrendered my universal life policy and got a cash out of $11,500
    I have paid over $17000 in premiums, will I be taxed on my cashout?

    • Hi Corey, assuming you have a $17,000 cost basis in the policy and had an $11,500 cash surrender value, no there should be no taxes owed upon the surrender.

  14. I am looking at cashing out my life insurance policy that I purchased in 1981. I am confused about the cash basis. The cash value is listed at $34,918. The annual premium is listed as $662.05 and the taxable gain is listed as $29456.92. Isn’t 662.05 X 40 years=$26482. Shouldn’t the gain be $8436? Where am I getting mixed up?

    • Hi Kirk, some possibilities are certain riders that do not count towards cost basis or previous activity that reduced the cost basis. Did you make any withdrawals or take dividends in cash? If none of this applies, you should call the insurance company and ask them to explain the cost basis/policy gain.

  15. Hi Brandon-

    My sister’s company has been sold. They told her she can “surrender” her life insurance policy and receive $11,321 cash. The insurance company sent her a Cost basis amount of $16,528 with a $0 taxable gain. The insurance company said said she will not have to pay taxes. The company paid all the premiums though so I assume we will have to report the $11,321 as income or pay taxes on this?

    Thank you

    • Hi Todd, this depends on the arrangement your sister had with “the company” (I’m assuming her employer?). If she paid income taxes on the premiums paid to the policy, there is a chance this is non-taxable cash value to her. You’ll need a tax professional to review and guide you from here.

      • Thank you Brandon for the reply –
        You are correct that the company is her former employer.
        She did not pay any taxes on the premiums herself (Her employer may have though). I will have her discuss with a tax professional.

        I will have her find out if the employer did pay the income taxes.

        As far as you would know or guess, if the employer did indeed pay the taxes, would that possibly exempt her from paying taxes on this?

        Thank you again

        • Hi Todd,

          Traditionally the employer wouldn’t pay the taxes for her per se, but would bonus her to compensate for the imputed income tax liability created by the benefit.

  16. Hi Brandon. We’re thinking about taking the CV of a small policy that my father in law took for my wife when she was 6 months old (she’s 61 now). We’ve been paying the premiums of $45 per year all these years and have never taken a loan out. By my calculations, we will owe taxes on approximately $711. I would like to know how this is reported. Will we receive a Form 1234 or a W-X or some other tax form from the insurance company? I haven’t been able to find where in the 1040 instructions to report this as income. Thanks!

  17. Hi,
    I have two whole life policies that I have been receiving 1099-INT forms on each year and reporting the income on my taxes each year. It seems like I have already paid taxes on the gains in these policies. Is this different from the gains you are talking about?

    • Hi Richard, the most likely reason you receive a 1099-INT is that you use the dividend option to accumulate at interest–read more about dividend options here. This doesn’t mean that you paid taxes on the cash value gain. You simply earned interest in an account held at the insurance company that is separate from your life insurance cash value.

  18. Great article!

    During a surrender and a gain is incurred, Is there any in kind transfer to another investment or loan that would exclude tax from being incurred (gain = the surrender values is greater than the basis)? You mentioned buying a different insurance policy would exclude taxable gains. But I already have enough insurance outside of Var. policy I am considering cashing out.

    But what about some other off the wall ideas? Like paying off a mortgage on a primary residence, transfer to a 529 college plan for my child, transfer to IRA (keeping contribution and income limits in mind) or transferring policy to our minor and then surrendering the policy? Would any of those ideas avoid the taxes on the gain?

    I have a $65k taxable gain situation after surrendering a variable life policy from 1986 with no loan on it. Just seeking some ideas to avoid or lessen the tax incurred as ordinary income tax. I would rather not incur this gain as ordinary income of some other ideas were out there.

    • You could transfer via 1035 exchange to an annuity to avoid paying taxes on the gain. That would allow you to transfer the entire cash value and incur no tax liability.

      Theoretically, if you cashed it out but then made a contribution to a tax-deductible plan (traditional IRA for example) this would offset the income you recognize from the surrender. Finding enough places to do this with the full $65,000 could prove challenging.

  19. Brandon, pls help me here. I have a veterans’ life insurance policy with face value upon death of $10,000. This was a 1956 gift from the VA and I have paid no premiums.
    The VA tells me the current value is $8869, plus $1355 in contributions (?), with a total of $10,224.
    If I elect to withdraw that total, will it be, or not be, totally taxable as ordinary income, or capital gains, or what? Please advise.

    • Hi Harry, you should always double-check this sort of thing with a licensed tax professional. Based on the information you provided, I would anticipate that the entire surrender amount of $10,224 would be income and taxed accordingly as ordinary income.

  20. Hi Brandon,
    Wondering if you can help my brother and I. Our mother was sold a 1 mil UL policy at 80 yrs of age and we’re primary owners. She put in a lump sum of $453K to pay for premiums. She didn’t consult us when she bought this and we have found out that by the time she turns 94, we’ll have to start paying premiums. The net cash value is now $322K. We think this is a terribly policy and upset that she was given this guidance. Our mother is now 88 yrs old, a very healthy one at that. We understand life insurance can be valuable yet it can be a risk as well. But our mother’s hard earned money appears to be going down the drain…no gains whatsoever! We want to cash out the policy before the money is gone. It’s a lot of money and we want to figure out a better way use for it. Do you know if my brother and I will have a tax liability? Or would my mother have tax liability? Or since we’re the policy owners, the money will be considered a gift and may still need to pay taxes on a gift? Just curious if you have a take on this or is it best to reach out to a financial advisor.
    Thanks so much for your insight and trying to help people with their problems.

    • Hi June, if there is less money in the policy cash surrender value than premiums paid, there shouldn’t be a tax liability upon terminating the policy. If your mother paid the premium, but then gifted ownership of the policy to you and your brother, then a taxable gift has already taken place–this can be reconciled at death with the lifetime estate/gift tax exemption. The gifted amount was the cash surrender value of the policy when ownership changed.

      There’s a chance you may not be an owner in the sense that you think you are, but instead hold some authority to discuss the policy with the insurance company–people can often confuse this. If this is the case, then mom is still the legal owner of the policy.

  21. Read somewhere that to “cash surrender ” a policy that was purchased prior to March 1989 does not involve paying taxes regardless of cost involved. Any truth about this? RN

  22. Brandon, really great info. Have a question. My former employer had a key man policy on me for $1,000,000. Upon retirement the police was given to me. The annual premium is $20k and since owing the policy the earnings have paid the premium. Currently there is $193,000 CV and I am considering cashing out. Would the premiums paid by my former employer or the ones paid by the CV since I’ve owned it count toward determining the gain. Thanks.

    • Hi Ken, because I don’t know all the details of the policy and the specific way it was used/set up as key man policy, I’m hesitant to weigh on on the cost basis. But the good news is you don’t really need my opinion on how it should work. The insurance company that issued the policy should have a record of the cost basis. This is what they would report to the IRS through a 1099 filing. You’ll receive this 1099 around tax time in the year following the surrender and will use it to calculate any tax liability while filing your taxes.

  23. I am planning to surrender a universal life policy I do not need that was purchased for me by my parents back in the early 1980’s. It is a cash out value of approximately 11000 with 6000 of that being a taxable “gain.” The insurance company sent me a surrender form along with a W4R. Do I need to withhold anything for taxes right now therefore reducing the amount I receive, or can I just pay the taxes owed when I file my taxes next year? Also, is there an additional 10% federal tax on top of what I would normally owe because I’m not yet 59 1/2?

    • Hi Lara,

      You do not have to withhold any amount from the cash surrender. That is optional to you. Do understand that in some cases the timing of a surrender and the amount owed to the IRS may require a payment sooner than next tax season to avoid a penalty for late payment of taxes. You should seek out the advice of a qualified tax professional if you need further guidance to figure out if that applies to you.

      There is no penalty for surrendering a life insurance policy for its cash value at any age.

  24. Hi Brandon,

    Very interesting topic. I have a question for you. I’m thinking of canceling my UL which will result in a gain of $75K (CV-P=G). Is it possible to rollover the full $75K to an IRA to avoid paying taxes now?

  25. Hello Mr Roberts,

    I have a Group Variable Universal Life Insurance policy through my employer that has a cash value of 1.1M and a cost basis of $500,000. I would like to withdraw my cost basis and then, after that transaction has been completed, do a 1035 exchange of the Universal Life policy for a an individual policy with the remaining cash value (earnings). I have taken no loans, no dividends, and all premiums were paid with after tax dollars. I have been told by an insurance agent (who is trying to sell me the individual policy) that this can’t be done because it would be considered a partial exchange & thus disallowed by the IRS. Thus I must transfer the entire 1.1M cash value (cost & earnings) of the Universal policy to the individual policy. Is this correct?

    • Hi Lee, the agent is correct. Any withdrawals taken from a policy within 180 days of a 1035 exchange is generally considered “boot income” under current Tax Code and you would receive a 1099 form the insurance company reporting $500,000 in income. You’d be a lot better off transferring the entire cash value to the new policy. Alternatively, you could surrender $500,000 now, and wait to perform the 1035 exchange. 180 days is the timeline the IRS has referenced in the past as being acceptable to separate withdrawals from boot income liability. I’m not guaranteeing that you will not incur the liability by taking the withdrawal, waiting 180 days, and then performing the 1035 exchange. Tax code can be vague and interpreted differently at different times.


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