What generally occurs when surrendering a policy for more than total premiums paid?

When a policy is surrendered for an amount greater than the total premiums paid, this results in a taxable event where the gain is recognized as ordinary income. The amount received that exceeds the policyholder’s basis (the total premiums paid) is subject to taxation. This is in accordance with IRS regulations that state that the gain from a life insurance policy must be reported as ordinary income for tax purposes.

In this context, the basis represents the amount that the policyholder has invested in the policy. Therefore, when the surrender value—the cash value received upon cancellation of the insurance policy—exceeds this basis, the difference is considered a gain. This gain will be taxed as ordinary income rather than capital gains, which is significant because capital gains usually have favorable tax treatment compared to ordinary income.

Understanding this principle is crucial for anyone involved with life insurance policies, as policyholders need to be aware of their tax implications when making decisions about their policies, including the possibility of surrendering them for cash.