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Tax on Insurance Policy Cash Outs
by Kimberly Lankford

This year we obtained a cash surrender of one of my wife's whole-life insurance policies. Is any part of what we received taxable and, if so, how much?

You may owe an income tax bill when you cash out a cash-value life insurance policy while you're still alive. To know the tax status of the payment, you'll need to know how much you paid in premiums over the years.

Even though the premiums bought you protection, the full amount you paid (minus any dividends you received on the policy) is your basis in the policy. The payout is taxable only to the extent that the amount you received exceeded your basis, according to Edward Graves, an insurance professor at the American College in Bryn Mawr, Pa., which provides financial education.

If you had any outstanding loans, their balance was subtracted before you received the payout. But you should use the full surrender value -- which includes the amount you received when cashing out the policy, plus any loans you haven't repaid -- to determine your tax liability. You should receive a form 1099-R showing the total payout and the taxable amount, which you'll report on your 1040.

The rules are different, however, for beneficiaries who receive a death benefit after the insured person dies. In that case, the beneficiaries don't owe any income taxes on the death benefits they receive and don't need to report the payout to the IRS.