When a cash value life policy is surrendered, which portion, if any, is subject to income tax?

When a cash value life policy is surrendered, the portion subject to income tax is the amount that exceeds the policy's basis. The basis refers to the total premiums paid into the policy over time. Upon surrendering the policy, if the cash value received is greater than the basis, the difference between these two amounts is considered taxable income. This is because the excess represents the gain on the investment in the policy.

For example, if a policyholder has paid $20,000 in premiums (the basis) and the cash surrender value is $25,000, then $5,000 ($25,000 - $20,000) would be taxable as income. This taxation aligns with the general principle in tax law that gains realized upon the sale or surrender of an asset are subject to income tax, while amounts returned that merely recoup invested capital (the basis) are not taxable.

The incorrect choices either misunderstand this principle or misrepresent the tax implications associated with the surrender of a life insurance policy.