Consumers can choose from two types of life insurance – term and permanent. As its name suggests, term insurance provides coverage for a period of time and the cost is cheaper than permanent insurance.
A permanent life insurance policy is similar to a savings account. You deposit money into the life insurance policy in the form of premiums, the insurer uses a portion of your deposits to pay for the life insurance benefit and the remainder is invested. If you pay for enough years, your policy builds up a cash surrender value, or CSV.
With both term and permanent insurance, proceeds from the death of the insured are tax-exempt. However, with permanent insurance, if you cash in a policy early, you may have taxable income. If the cash surrender value amounts to more than the premiums and you surrender or cancel the policy, the excess is considered earnings and taxable income.
For example, if you paid $1,000 in policy premiums for 20 years and you cash in the policy and receive $30,000, you’ll pay ordinary income tax on $10,000 in earnings.
You should receive a Form 1099-R showing the total proceeds and the taxable part. Report these amounts on lines 4a and 4b of Form 1040.
In certain cases, accelerated death benefits are not taxable income if the insured is terminally or chronically ill. This is generally referred to as a viatical settlement. This differs from a surrender of the policy to the insurer. If you’re contemplating a surrender of the policy because of need resulting from a terminal illness, you may be better off with a viatical settlement.