Cash value is one of the appealing features of permanent life insurance, but pulling money out of it isn’t always as simple as withdrawing from a savings account. How a withdrawal or full surrender is taxed depends on a few specific rules, and getting caught off guard by them is a completely avoidable mistake.

The basic rule: your own money comes out first

Most policies follow a “cost basis first” rule, sometimes called FIFO. Cost basis is generally the total premiums you’ve paid into the policy over the years. Withdrawals up to that basis are typically treated as a tax-free return of your own money. Only amounts withdrawn beyond your cost basis, representing actual growth in the policy, are taxed as ordinary income in the year you take them out.

Fully surrendering a policy is a different calculation

If you cancel a policy entirely rather than taking a partial withdrawal, the taxable amount is generally the total cash value received minus your total cost basis, all recognized in the year of surrender. If there’s an outstanding policy loan, the loan is typically paid off out of the surrender proceeds first, which can produce a larger taxable gain than you’d expect from the check you actually receive. That’s the same mechanism behind the lapse trap that can catch policyholders with an outstanding loan by surprise.

Modified Endowment Contracts flip the order

If a policy has been overfunded enough to become a Modified Endowment Contract, the tax treatment of withdrawals changes to a “gain first” (LIFO) rule, meaning withdrawals are taxed as income before any basis comes out tax-free, and a withdrawal before age 59½ can also trigger an additional 10% penalty on the taxable portion, similar to an early retirement account withdrawal. Knowing whether a policy is a MEC matters a great deal before taking any money out of it.

Expect a 1099-R for any taxable amount

When a withdrawal or surrender produces taxable income, the carrier reports it to you and the IRS on Form 1099-R. It’s worth keeping your own records of premiums paid over the years, especially for an older policy or one that came from a 1035 exchange, since your cost basis may need to be tracked across more than one contract.

Before you withdraw or surrender

Ask for a current in-force illustration that shows your cost basis and an estimate of any taxable gain before taking money out of a policy. Depending on your goal, a partial withdrawal, a policy loan, or a 1035 exchange into a different contract may accomplish what you need with a very different tax result — it’s worth comparing the options rather than defaulting to the first one that comes to mind.

This article is educational and general in nature. It isn’t personalized tax advice, and tax treatment can vary by policy and individual circumstances. Consult a qualified tax professional before making withdrawal or surrender decisions.