There are basically two types of life insurance policies: term life and whole life.
Term life includes an insurance component only. The premiums are quite inexpensive compared to whole life policies. A middle-aged non-smoker in good health can get a $250,000 term life policy for around $200/year. The insurance contract stipulates a period of level premiums. For example, if you have a ten-year policy, the premiums will stay the same for all ten years. If the term expires without the insured person dying, the contract ends. Premiums are forfeit. There is no taxable event. If the policy lapses due to nonpayment of premiums, the premiums are again forfeit and there is no taxable event.
Whole life policies have both an insurance component and a savings component. Whole life policies do not expire. Either the insured dies, or the policy owner surrenders the policy before the death of the insured. Policy lapse is treated as a surrender. There are all sorts of whole life policies. Some can be very expensive. For the sake of comparison, I am going to suppose a policy with premiums that stay the same for the life of the policy.
A level-premium whole life policy is very expensive in the early years. As the policy ages, the premium, as a percentage of the policy owner’s income, become less and less because of the rate of inflation. Have you ever discovered an old letter with a 25 cent stamp? Stamps today are nearly twice as much. Those level premiums are like paying 25 cents to get a 45 cent stamp.
When the insured dies, the policy’s death benefit will be paid to the designated beneficiary. If you are a beneficiary you will not have to pay tax on the life insurance proceeds you receive. However, if insurance proceeds are paid in installments with the principal earning interest, the interest portion only will be taxed as ordinary income.
The thing is most whole life policies never get around to paying the death benefit. The owner usually surrenders the policy long before the death of the insured. It takes many years for the surrender value to build until it exceeds the premiums paid. Depending on the age of the policy, the surrender could very well create a taxable event.
Let’s say you buy a whole life policy with a $1000 annual premium. You pay your premiums faithfully for ten years and then surrender the policy. The life insurance company sends you a check for the surrender value, for example, $6,700. Since the amount of the check is less than the total premiums paid, $10,000, there will be no tax. However, if you do not report the income, the IRS will send you a letter. The insurance company sent the IRS (and you) a report of the proceeds. The IRS knows nothing about the history of the policy. It will assume the entire amount is taxable income unless you report otherwise on your tax return.
In another case, let’s say the life insurance company sends you a check for $13,000. You will owe tax on the $3,000 difference between the surrender value and total premiums paid. That $3,000 is income taxed at the same rate as your ordinary income reported Forms W-2. If it should happen that the surrender value is less the amount of premiums paid, the loss is not deductible.
For most people, the tax consequence of surrendering a whole life insurance policy are minimal because most policies are surrendered before surrender value exceeds premiums paid. However, if you own an old policy, the tax bite could be substantial. You may need to consult an adviser, preferably not an insurance agent who are too likely to propose strategies that involve purchasing new insurance. The agent wants that big commission. You should be wary of any agent that advises you to cancel an existing policy and use the proceeds to purchase a new policy.