Certain life insurance, such as whole life, carries a cash value with the policy. The premiums you pay each month go towards a certain amount of coverage for your beneficiaries when you die. In addition, a certain portion of your premium can go into a cash value account which grows tax-deferred over time. If down the road you determine the amount of coverage is no longer necessary, or that you would rather reinvest the cash value of the policy, you can cash in that policy. Beware, the cash you receive may be considered income.
The insurance policy is treated like most other investments: the excess of the cash received over your investment will be considered income. The cash value is the amount you receive from the insurance company. The investment in the contract is generally the total amount of premiums paid. Chances are, the cash surrender value of the policy will not exceed the amount of premiums paid, and therefore there will be no income. However, if the cash you receive exceeds your investment, that amount is considered income, and must be reported on your income tax return.
The Brown's learned the hard way that any amount received from surrendering a portion of the policy at an earlier time is considered a reduction in the investment in the policy. (See Brown v. Commissioner, a September 11, 2012 decision for the 7th Circuit that is not yet published.) The IRS assessed a 20% penalty for substantial underpayment of tax. On appeal, the 7th Circuit made sure to point out the taxpayers were both attorneys and they had made no effort to obtain an opinion from an accountant or lawyer in determining the amount that was taxable. Learn from their mistakes and see a tax professional if you plan to terminate a life insurance policy.