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Updated July 31, 2026. Quick answer: selling a policy is taxed in three tiers (Rev. Rul. 2009-13): (1) proceeds up to your cost basis — tax-free; (2) proceeds from basis up to the cash surrender value — ordinary income; (3) everything above cash surrender value — long-term capital gain. Surrendering has only the first two tiers. The three-tier structure is why a settlement’s premium over cash value is taxed more gently than the same dollars would be inside a surrender.
Worked example
Basis $60,000, cash value $110,000, settlement price $175,000. Tier one: $60,000 tax-free. Tier two: $50,000 ordinary income (the gain a surrender would have produced). Tier three: $65,000 long-term capital gain. Versus surrendering: you’d receive $110,000 with the same $50,000 of ordinary income — the settlement adds $65,000 of price at capital-gain rates.
Two facts that changed in your favor
Basis is no longer reduced by the cost of insurance. The 2017 tax act reversed that part of the 2009 ruling retroactively (TCJA §13521; Rev. Rul. 2020-05) — basis is simply premiums paid, net of dividends taken and withdrawals, which makes tier one bigger and tier two smaller than older articles claim. And terminally or chronically ill sellers may owe nothing at all — viatical settlements for the terminally ill are generally excluded from income entirely under IRC §101(g). Compute your basis first: cost basis, done right · the decision itself: settlement vs surrender.
Three tiers, and the paperwork lands on next year’s return.
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