Upon surrendering a life insurance policy, which portion of the cash value is taxed?

When a policyholder surrenders a life insurance policy, taxation comes into play regarding the cash value that has accumulated within the policy. The pertinent tax principle here is that the policyholder is taxed only on the amount of the cash value that exceeds the total premiums paid into the policy.

In other words, if a policyholder has paid a total of $20,000 in premiums but the cash value at the time of surrender is $25,000, only the $5,000 that is the excess over the paid premiums would be taxable. This taxation reflects the gains or earnings on the policy, rather than the amount that has already been contributed through premiums, which are not considered taxable income since they were already taxed when earned.

The options illustrating what portion of the cash value is taxed relate to this concept: the entire cash value would imply taxing both the contributions and gains, which is not accurate. Claiming none of the cash value is taxed does not align with tax regulations since any excess over premiums is subject to tax. Taxing the amount equal to the premiums paid also misrepresents the taxation process because that portion is simply a return of investment rather than taxable income. Thus, understanding that tax is levied only on gains above the original investment