When an existing life insurance
policy is no longer needed or
affordable, many people turn
in their policy for cash surrender
value. With the growth of the life
insurance settlement market,
many people are also selling their
policies. The cash surrender value
or sales proceeds are taxable but the
owner does have a cost basis that
can be claimed to reduce the
taxable income/gain.
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How do you determine the cost basis of your policy and proper tax treatment? There
are three questions that must be answered to determine the correct approach:
1. Are you the original purchaser of the policy from the insurance company? If you
bought the policy from the original purchaser (called transfer for value), the tax
treatment described below does not apply to you.
2. Is the policy being sold to an unrelated party (who would suffer no economic loss
upon your death) or is it being surrendered for cash surrender value?
3. Is the policy being sold a whole life or level term type policy?
For whole life policies sold to an unrelated party by the original owner, your cost
basis is the total premiums paid since inception less the insurance charges assessed
since inception. It is essential to obtain an up-to-date policy illustration prior to
any sale in order to obtain the relevent insurance charges. The difference between
the premiums paid since inception and the cash surrender value represents "inside
buildup" and is taxed as ordinary income. The remainder of your gain is taxed as
long-term capital gain.
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In contrast, if you are the original owner
and turn your policy back into the
insurance company for the cash surrender
value, your basis is the premiums paid
since inception, less cumulative distrib-
utions and loans against the policy.
All of the gain is ordinary income and
none is eligible for capital gains treatment.
Let's look at an example to see how this
works in actual practice and to compare
the net after-tax proceeds for each
alternative:
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Life Insurance Calculator
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| Life Insurance Calculator |
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Assume that you have a $250,000 whole life policy that can be surrendered for $78,000
or sold to an outside party for $80,000. The premiums you have paid since you bought
the policy amount to $64,000. You have not made any withdrawals from the policy in
the form of distributions or loans. From your latest policy illustration, you see that the
cumulative insurance charges have been $10,000. You are in the 33% marginal income
tax bracket. Let's compare your after-tax gain for the two methods of disposal:
Surrender Sell
Proceeds $78,000 $80,000
Cost Basis 64,000 54,000 (64,000 less 10,000)
Taxable Amount 14,000 26,000
Amount taxed as ordinary income 14,000 14,000 (78,000 less 64,000)
Amount taxed as long term capital gain 0 12,000
Tax on ordinary income @ 33% (4,620) (4,620)
Tax on long term capital gain @15% 0 (1,800)
Total taxes owed (4,620) (6,420)
Net after-tax proceeds $73,380 $73,580
Thus we see that in this example most of the higher proceeds from selling the policy are
eaten up by higher taxes. Of the increased proceeds of $2,000 ($80,000 sales proceeds
less $78,000 cash surrender proceeds), only $200 ends up in your pocket.
You can use our free life insurance sales calculator to compute your own estimated
after-tax proceeds for life insurance settlement bids versus cash surrender value
quotes.
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If the life insurance policy being sold by the original owner is a term policy, there is a
different twist. Similar to sales of whole life policies, your cost basis for a term
policy is the cumulative premiums paid less the cost of insurance since inception. For
regular term policies, the premiums paid are normally equal to the actual cost of insur-
ance each period, so your cost basis is zero at the end of any premium period. How-
ever, if a term policy is sold in the middle of a premium period, your cost basis is the
unearned premium for the remainder of the period (which could be a month, quarter,
or year.) All of the gain is taxed as long-term capital gain.
For level term policies, however, there is an "inside buildup" of value because a higher
premium is charged in the early years to allow for a lower premium in the later years
(producing a level premium payment.) This is true even if there is no formal cash
surrender value available. If you can get a printout from your insurance company to
demonstrate the internal build up and draw down, you can use it to document your
cost basis in the level term policy. In the absence of this proof, you must treat it the
same as a regular term policy, i.e. zero cost basis except for unearned premiums. All
of the gain is taxed as long-term capital gain.
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