When a life insurance policy is sold, the tax bill will depend on the amount paid and the seller’s basis in the policy, which usually will be the total amount of premiums paid. Suppose, for example, Janet Baker has a $500,000 policy she no longer needs. Over the years, Janet has paid $80,000 in premiums and has taken no withdrawals or cash dividends.
At the time of the sale, Janet’s policy has $100,000 in cash value. She sells the policy for $125,000.
* The $20,000 difference between Janet’s basis (the $80,000 she paid in premiums) and the $100,000 cash value will be taxed as ordinary income, at rates up to 35 percent.
* The $25,000 excess of the purchase price ($125,000) over the cash value ($100,000) will be taxed at only 15 percent, as a long-term capital gain.
What if a term life policy is sold? These policies have no cash value. The IRS has not said that the gain will be taxed as ordinary income so you might decide to treat any profit as a long-term capital gain.