Calculating Taxable Income when Surrendering a Whole Life Insurance Policy Before Death

In general, whole life insurance involves overpaying ten times the cost of term insurance and placing that extra money into a separate account.

The State of California categorizes Whole, Universal, Variable, Indexed and several others under the category of Whole Life Insurance (as opposed to Term Life Insurance).

In order to determine the gain within a Whole Life Insurance policy, you must first calculate the cost basis.  The cost basis in most cases is just the total amount of premiums paid on the policy (see finance.zacks.com for more information).  In rare cases, there may be distributions in which case the distributions will reduce the cost basis.

Next, you determine the surrender value.  A common misconception is that a life insurance policy is worth the account value.  However, a more accurate estimation of value is today's value, which is the surrender value.

Gain = Surrender Value - Premiums

Compare this to a typical gain for any investment, such as a home:

Gain = Sale Price - Cost Basis

The Gain will be taxed under the IRS code 7702.  This gain is reported as ordinary income.  This is unfortunate, because most policies result in a loss and a capital loss would have the option to be offset with a capital gain.