Many policyholders are surprised to learn that cashing in a life insurance policy may lead to unexpected tax liability. While a policy’s cash value can be an appealing source of funds, the IRS may treat part of the proceeds as taxable income depending on how the funds are accessed. The tax consequences of cashing in a life insurance policy depend on several factors — including your policy type, how much you’ve paid in premiums, and how you access the funds.
When you surrender a policy for its accumulated cash value, you may owe taxes on any amount that exceeds the total premiums you’ve contributed. However, the rules can vary widely between term and permanent coverage, as well as between full life insurance cash value surrender and partial withdrawals or loans. This guide will walk you through how life insurance taxation works, common exceptions, and the strategic alternatives that may offer better financial outcomes.
Whether you’re considering surrendering your policy or exploring options such as a life settlement, understanding the tax consequences of cashing in a life insurance policy can help you make an informed, financially sound decision.
Key Takeaways
- When taxes apply: Cashing out is taxable only if the payout exceeds your total paid premiums.
- Cost basis vs. gain: Premiums paid are your cost basis; any amount above that is taxable income.
- By action:
- Surrendering – Taxes may apply to gains.
- Loans – Generally tax-free as long as the policy remains active; taxable if it lapses or becomes a MEC.
- Selling – Profit above cost basis is taxable.
- Viatical settlements: Tax-free for terminally ill policyholders.
- Ovid’s role: Ovid helps policyowners evaluate their policy’s value and potential tax impact before making a decision.
What It Means to Cash In a Life Insurance Policy
To “cash in” or “cash out” a life insurance policy means converting it into accessible funds—either by surrendering it to your insurer or selling it to a third-party buyer. This option primarily applies to permanent life insurance policies, such as whole or universal life, which accumulate cash value over time. Policyholders can choose to surrender their policy for its cash surrender value or explore selling it through a life settlement for a potentially higher payout. Learn more about selling whole life policies here.
Term life insurance, on the other hand, typically has no cash value. However, if the policy is convertible, it can sometimes be sold through a life settlement once converted into permanent coverage. See how term policies can qualify. Understanding the distinctions between surrendering and selling a policy sets the stage for exploring the tax consequences of cashing in a life insurance policy and for navigating them strategically. Learn more about policy surrender and cash value.
What is Cash Value?
The cash value of a life insurance policy is the savings component that grows over time through premium payments and interest accumulation. It represents the portion of your premiums that exceeds the cost of insurance, building a reserve that can be withdrawn, borrowed against, or accessed if the policy is surrendered. Find out how cash value works in detail.
Net Cash Surrender Value vs. Account Value
While the account value reflects your policy’s total accumulated funds, the net cash surrender value is the actual amount you’d receive after subtracting surrender fees, outstanding loans, and unpaid premiums. This distinction is key to setting realistic expectations when cashing out or surrendering your policy.
Role of Surrender Charges
Surrender charges are fees insurers impose when a policy is terminated early, typically within the first several years. These charges can significantly reduce your payout and should always be considered when deciding whether to access your policy’s cash value.
Tax Implications of Cashing Out
The tax consequences of cashing in a life insurance policy depend on how you access the funds–through surrender, loans, or a sale. Understanding these differences can help you anticipate when taxes may apply and avoid unexpected liabilities.
Understanding Cost Basis and Taxable Income
Your cost basis is generally the total amount of premiums paid into your policy, minus any dividends or withdrawals previously received. Any payout above this amount is considered a taxable gain and is reported as ordinary income, not a capital gain.
Example: If you’ve paid $50,000 in premiums and surrender the policy for $70,000, the $20,000 gain is taxable.
Tax Implications of Policy Surrender
When you surrender a permanent policy for cash value, any amount above your cost basis is treated as taxable income. Insurers will issue IRS Form 1099-R if the payout exceeds your total paid premiums. Keep in mind that surrender charges or unpaid loans may reduce your final cash value.
Modified Endowment Contracts (MECs)
A Modified Endowment Contract (MEC) occurs when too much money is paid into a life insurance policy, exceeding IRS funding limits. A policy becomes an MEC if it fails the IRS’s ‘7-pay test,’ which limits how much premium can be paid relative to the death benefit within seven years.
IRS Early Withdrawal Penalty
If you withdraw from a MEC before age 59 ½, you may owe a 10% penalty in addition to income tax on any gains. This rule does not apply to standard, non-MEC policies unless reclassified by the IRS.
Tax Consequences of Selling Your Policy in a Life Settlement
When selling your life insurance policy through a life settlement, taxes are based on how the sale proceeds compare to your cost basis and surrender value. Learn more about selling your term policy.
Tax Breakdown of a Life Settlement
The IRS applies a three-tier structure to life settlements:
- Up to your cost basis: Not taxed
- From cost basis to the policy’s cash surrender value: Taxed as ordinary income
- Above the cash surrender value: Taxed as capital gain
Sellers receive IRS Form 1099-LS to report proceeds from the sale.
Tax Advantages of Viatical Settlements
A viatical settlement allows someone with a terminal illness (life expectancy of two years or less) to sell their policy for cash. Under IRS rules, proceeds from a viatical settlement are tax-free when specific conditions are met, offering crucial financial relief for medical or end-of-life expenses. Learn how viatical settlements are taxed.
Strategies and Alternatives to Cashing Out
Not every policyholder needs to surrender or sell their policy outright. Several strategies allow you to access value while reducing taxes or maintaining coverage.
Policy Loans and Borrowing Against Life Insurance
Loans taken against a policy’s cash value are generally not taxable as long as the policy remains active. However, if the policy lapses with an unpaid loan, that amount becomes taxable income. MECs are an exception—loans from MECs are immediately taxable.
Medicaid Planning
Because the cash value of permanent life insurance is considered a countable asset for Medicaid eligibility, owning a policy with more than a minimal face value can affect qualification. Surrendering or selling a policy may help with spend-down strategies, but timing is crucial. Always consult a Medicaid or elder law specialist before proceeding.
Consulting with Financial Experts
Before deciding to cash in, surrender, or sell a policy, it’s essential to consult a tax advisor, CPA, or financial planner. These professionals can evaluate how your tax bracket, health, and financial goals align with your options and help you minimize tax exposure.
When Cashing In Makes Financial Sense
Cashing in a life insurance policy may make sense when:
- The policy is no longer needed or affordable.
- Premiums outweigh the long-term benefits.
- Immediate cash is required for retirement, healthcare, or long-term care.
Before deciding, compare your surrender value against potential life settlement offers to determine which option best aligns with your financial goals.
How Ovid Helps You Understand the Full Value of Your Policy
Deciding whether to surrender or sell a life insurance policy can be complex, especially when taxes and long-term financial goals are involved. Ovid helps policyholders navigate these decisions by providing expert insights into every available option — including surrendering the policy for its cash value or selling it through a life or viatical settlement. With Ovid’s guidance, you can clearly understand how each path affects your coverage, payout, and potential tax obligations.
Ovid also offers free, no-obligation policy estimates to help you determine what your life insurance policy is truly worth before you make a final decision. Their team walks you through how the IRS treats different types of transactions — explaining the tax implications of surrendering, borrowing against, or selling a policy — so you can make an informed, financially sound choice.
For many policyholders, a life settlement through Ovid uncovers hidden value that far exceeds the policy’s surrender amount. Instead of accepting a smaller payout from your insurer, you could access a higher return while relieving yourself of ongoing premium payments. Get a free, no-obligation quote and find out what your life insurance policy is really worth—before you cash it in.
Frequently Asked Questions About the Tax Implications of Cashing Out Your Life Insurance Policy
Do I have to pay taxes if I surrender my life insurance policy?
Only the amount you receive above what you’ve paid in premiums (your cost basis) is taxable, and it’s generally treated as ordinary income.
What happens if I take a loan and the policy lapses?
If your policy lapses with an unpaid loan balance, that amount is considered taxable income by the IRS.
Are life settlements taxable?
Yes, portions of a life settlement may be taxed as ordinary income and capital gains, unless the policyholder is terminally ill, in which case the proceeds are typically tax-free.
What forms do I need to file with the IRS?
You’ll receive Form 1099-R for a surrender or Form 1099-LS for a life settlement—usually sent by the insurer or settlement provider for tax reporting.
How can I avoid taxes when cashing in a life insurance policy?
Choosing a viatical settlement or ensuring your payout stays below your cost basis can help minimize or avoid taxes, but personalized tax advice is always recommended.
