If a policyowner cashes in a policy for more than the premiums paid, how is the excess amount taxed?

When a policyowner decides to cash in a policy and receives an amount greater than the premiums they have paid, the tax implications are significant. The excess amount is considered the gain or profit derived from the policy. Under tax regulations governing life insurance, only the gain—or the amount over the total premiums paid—is subject to taxation.

This is founded on the principle that the premiums paid into the policy are treated as a return of the policyowner's own investment. When cashing in the policy, if the payout exceeds the sum of the premiums contributed, the excess reflects a profit, which is taxable. Therefore, only the gain is taxed, while the premiums returned are not.

In contrast, options that suggest full taxation or no taxation misinterpret how the IRS treats life insurance gains, and taxation as income at retirement doesn't apply in this context, as it is a straightforward transaction rather than one specifically tied to retirement income. Thus, understanding the distinction between returned premiums and taxable gains is essential in grasping why only the gain is taxable.