588 / If a policyholder elects to receive endowment maturity death benefit proceeds, or cash surrender values under a life income or installment option, is the gain on the policy taxable to the policyholder in the year of maturity/death/surrender or as payments are received?

When an endowment contract matures, a death benefit becomes payable, or when any type of contract is surrendered, a lump sum payment generally becomes available to the policyholder unless, before the maturity or surrender date, the policyholder has elected to postpone receipt of the proceeds under a settlement option.

However, a lump sum will not be considered constructively received in the year of maturity or surrender if, within 60 days after the lump sum becomes available and before receiving any payment in cash, the policyholder exercises an option or agrees with the insurer to take the proceeds as an annuity.²

The 60-day extension is allowed only for the election of a life income or other installment-type settlement (those considered annuities ( Q 495)). It does not apply to an election to leave the proceeds on deposit at interest; if a taxpayer wishes to make an election to leave proceeds on deposit at interest and still defer taxation, such an election must be made before maturity or surrender (if available under the contract) to avoid constructive receipt ( Q 21).

If there is a gain on the contract but the proceeds are not constructively received and instead are received as a life income or installment-type settlement as an annuity, the policyholder is not taxed on the gain in the year of maturity or surrender. Instead, the amounts are taxed as “amounts received as an annuity” when payments are made, under the standard rules applicable to such payments.

If there is a gain on the contract and the proceeds are constructively received (as where the election is made after the 60-day period), the full gain is taxable to the policyholder in the year of constructive receipt as if he or she actually had received a one sum cash payment ( Q 51). Because gain has been recognized, if the contract is subsequently annuitized the investment in the contract (cost) would not be premium cost but would be the entire lump sum applied under the settlement option (as though the contract had simply been surrendered with the proceeds reinvested into a new contract as a separate transaction). Although the larger cost would result in a larger excludable portion for the annuity payments, it usually is advisable for the policyholder to avoid being taxed on the entire gain in one year in the first place.

Even where the cash surrender value is less than net premium cost, it appears that net premiums may be used as “cost” in determining the exclusion ratio for the annuity payments, provided the cash surrender value is not constructively received in the year of surrender.³