Even when a client purchases a “permanent” type of life insurance policy (such as a whole life policy), situations can arise in which the investment may simply no longer make sense.
If this is the case, the client may consider either selling or surrendering the policy in order to free up those assets for allocation toward more advantageous investment products. However unnecessary a life insurance policy investment may have become, the client must be sure to carefully evaluate the detailed tax consequences that the IRS has outlined in a variety of rulings in order to gain a comprehensive picture and ensure that a sale or surrender is a wise choice.
Tax Consequences Upon Sale or Surrender
While life insurance policy loans and death proceeds are generally received income-tax free, the same favorable tax treatment does not necessarily apply upon sale or surrender of a policy.
Gain on a life insurance policy is measured as the difference between the client’s basis in the policy (usually the amount of premiums that he or she has paid) and the policy’s cash value. The cost of insurance is also subtracted from the amount of premiums the client has paid to arrive at the basis figure.
Generally, when a life insurance policy is sold to an investor (a transaction often referred to as a “life settlement”), the policy owner will be required to recognize ordinary income to the extent of his or her “gain” on the contract. If the client receives amounts in excess of the cash value upon the sale, that excess amount is taxed as capital gain.
One problem that clients will often encounter is how to determine the cost of life insurance protection that must be subtracted in order to determine the contract’s basis. While the IRS does not offer definitive guidance, this figure can usually be obtained from the insurance company issuing the policy.
If the policy is surrendered, the client’s tax liability must be calculated by first determining his or her investment in the policy under IRC Section 72. Investment in the policy is generally the amounts paid for the insurance minus any amounts that had already been received under the insurance policy (loans, for example) that were excluded from gross income. The excess of what is received over the investment in the contract is taxed as ordinary income.
The Typical Candidate and Other Non-Tax Considerations