I cashed in an insurance policy. Is the amount I received from it considered earned income, dividends or interest?
When you surrender an insurance policy, generally most of what you receive is a return of the premiums you paid for the policy. Since premiums paid for the policy were never deductible, the return of the premiums is not taxable.
If the policy performed well, then you may have received more than the premiums upon its surrender. This is considered ordinary income and is reported on line 7 of your 2003 Form 1040. The insurance company will issue you a Form 1099 reporting the gross amount that you received and, provided they have sufficient information, the amount that may be taxable, if any.
If the insurance company is unable to tell you the taxable amount, you need to compile a record of what you paid in premiums. Sometimes an insurer cannot tell you what you paid as it may have acquired the policy in a merger or the policy may be quite old. However, you should not hesitate to reduce the amount you received by your actual premiums. Depending on how long you have had the policy, it would not be surprising to find that none or only 10 percent to 20 percent of what you received is actually taxable. If you paid more premiums than you received in return, the loss is not deductible.
The older that an insured gets, the more sense it may make to cash in an insurance policy. As the insured ages, the cost of the insurance gets expensive and begins to eat into the value of the policy or makes the annual costs of maintaining the policy quite expensive. Additionally, as you age, the need for the face value of the policy may not exist as sufficient other assets may be available. A professional accountant or trusted insurance adviser can help you make a determination as to whether to maintain the policy or surrender it.
If the cash value in the policy is needed, you can also consider borrowing from the policy, which would not be taxable.