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.
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.
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
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:
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.
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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Information provided is intended solely for U.S. individual cash-basis taxpayers and is believed to be accurate for most cases. Always consult your personal tax advisor about your own situation. Suggestions are most welcome. Please e-mail webmaster @ costbasis.com or write to us at P O Box 11022, Chicago IL 60611 with your comments.