What are the tax implications when a life insurance policy is surrendered for its cash surrender value?

POLICY SURRENDER TAXATION follows the FIFO (First In, First Out) rule and the return-of-basis principle.

The math: The policyowner's COST BASIS = total premiums paid − any dividends received (if dividends were paid tax-free); the TAXABLE GAIN = CSV − Cost Basis; the taxable gain is taxed as ORDINARY INCOME (not capital gains); the amount up to the cost basis is a return of after-tax premiums — no additional tax.

Example: Client paid $50,000 in premiums over 20 years. Received $2,000 in dividends (excluded from income previously). Cost basis = $48,000. CSV at surrender = $75,000. Taxable gain = $75,000 − $48,000 = $27,000. The $27,000 is reported as ordinary income.

Outstanding loans: If there is an outstanding loan at surrender and the loan exceeds the cost basis, the gain may still be taxable even though the owner doesn't receive that cash — the loan is treated as constructive receipt.

Contrast with death benefit: Death benefits are income tax-free to the beneficiary (IRC 101(a)); the surrender tax rules apply only to living surrenders, not death claims; MODIFIED ENDOWMENT CONTRACT (MEC): If a policy becomes a MEC (premiums exceed 7-pay test limits), all distributions including surrenders and loans are subject to income tax on gains first and a 10% penalty if under age 59½ — the LIFO rule applies to MECs, not FIFO.