A disposition occurs when the policy owner gives up all or part of their interest in the policy. Disposition events include:
- Full surrender (cash surrender value received).
- Partial withdrawal from the accumulation account (UL or participating policy dividend withdrawals).
- Policy maturity.
- Assignment of the policy for consideration (selling the policy).
Tax on surrender: the policyholder must include in income the amount by which the policy's proceeds of disposition exceed the policy's ACB at the time of surrender. The entire gain is taxed as ordinary income (not a capital gain); there is no preferential half-inclusion rate for life insurance policy gains.
Partial withdrawal (UL policies): a partial withdrawal from the accumulation account is treated as a partial disposition. A proportionate share of the ACB is allocated to the withdrawn amount; if the proceeds of the partial disposition exceed the allocated ACB, the difference is income.
Policy dividends: dividends from a participating policy reduce the ACB (when left in the policy or used to purchase paid-up additions) or are taxable income (when received as cash above ACB). Dividends used to reduce premiums are applied against ACB.
Recall: A client surrenders a whole life policy and receives $95,000. The ACB at surrender is $40,000. How much is included in income?