21 / What are the tax consequences of leaving life insurance cash surrender values or endowment maturity proceeds with the insurer under the interest-only option?

The interest is fully taxable to the payee as it is received or credited.¹

Under some circumstances, election of the interest option will postpone tax on the proceeds. If the option is elected before maturity or surrender without reservation of the right to withdraw the proceeds, the proceeds are not constructively received in the year of maturity or surrender.² But if the right of withdrawal is retained, the IRS apparently considers the proceeds as constructively received when they first become withdrawable.³ (It can be argued, however, that the proceeds are not constructively received when the policyholder has a contractual right to change to another option.) If the option is elected on or after the maturity or surrender date, the proceeds are constructively received in the year of maturity or surrender. The 60-day extension rule, applicable to the election of a life income or installment option, does not apply to an election of the interest option (see Q 52 and Q 588 for exclusion of exception).

If the proceeds are constructively received, the entire gain on the contract (if any) is taxable in the year of constructive receipt as if the proceeds had been actually received in a one sum settlement. If the proceeds are not constructively received, the gain will be taxable to the person who ultimately receives the proceeds.⁴