AD Banker Comprehensive Practice Exam

What typically governs the taxation of cash surrender values when a policy is cashed in?

1. The amount of premiums paid

2. The policyholder’s age

3. The cash surrender value

4. The policyholder’s income level

The correct answer is: The amount of premiums paid

The taxation of cash surrender values when a policy is cashed in is primarily governed by the amount of premiums paid into the policy. This reflects the underlying principle that the policyholder typically receives a taxable gain only from the amount that exceeds the total premiums paid. When a policy is surrendered, the cash value received is compared against the total premiums the policyholder has contributed. If the cash surrender value is greater than the total premiums paid, the difference is considered taxable income. Therefore, the amount of premiums paid directly affects how much, if any, is subject to taxation upon cashing in the policy. This mechanism is designed to ensure that individuals are not taxed on funds that they have already contributed, but only on any gain realized from the policy. The policyholder's age, the cash surrender value itself, and the policyholder's income level do not determine the taxation of the cash surrender value in the same fundamental way that premiums do. These factors may influence other aspects of insurance or financial planning but not the direct tax implications associated with cashing in a policy.