Surrendering or reducing a permanent policy

What you actually receive

The cash surrender value, which is the accumulated cash value less any surrender charge set out in the contract. Once it is paid, the coverage ends. There is no residual claim and no death benefit.

In the first several years that figure is usually well below what you have paid in premiums, sometimes dramatically so. Year one is often zero. The reason is that early premiums cover the insurance itself plus the cost of putting the policy on the books, and only what is left starts accumulating. See cash value and how it builds.

Anyone surrendering a policy in its first decade should expect to take a loss, and should be sure there is no better option first.

The tax bill people do not expect

This is the part that produces genuinely unpleasant surprises.

A surrender is a disposition of an interest in a life insurance policy. Where the amount you receive exceeds the policy’s adjusted cost basis, the excess is a policy gain and is included in your income for that year.

Two things make it worse than people assume.

It is ordinary income, not a capital gain. There is no fifty percent inclusion rate. The whole gain is taxable at your marginal rate.

The adjusted cost basis falls over time. It goes up with premiums paid and down with the cost of insurance charged and with dividends credited. On an older participating policy the adjusted cost basis can be much lower than the total premiums paid, which means a policy that feels like it has barely broken even can still produce a substantial taxable gain.

The insurer issues a T5 for the year. Ask for the projected taxable amount before surrendering, not after.

The two alternatives nobody mentions

Both keep coverage in place and neither triggers an immediate tax event.

Reduced paid-up. The cash value is used to buy a smaller amount of fully paid-up permanent coverage. No further premiums are ever due, and the reduced coverage continues for life. For someone who can no longer sustain the premium but still wants a death benefit, this is very often the better answer than surrendering. It is rarely offered unprompted.

Reduce the face amount. Keep the policy but lower the coverage, which lowers the premium. Useful where the original amount was sized for obligations that have since gone away.

There is also premium offset on a participating policy, where accumulated dividends cover the premium. That is a projection rather than a guarantee, and premiums can resume if the dividend scale falls. See participating policies and dividends.

Reasons people surrender, and whether they hold up

“I cannot afford it.” Look at reduced paid-up first, then at reducing the face amount. Surrendering is the last of the three, not the first.

“I do not need the coverage any more.” Sometimes true, particularly where the policy was bought for a need that has ended. Check whether the estate would face a tax liability before concluding the need is gone. See estate planning.

“I need the money.” Compare against borrowing against the policy, which keeps the coverage. Also weigh the tax bill, because the after-tax amount is smaller than the cheque.

“Someone showed me a better policy.” Be careful. Replacing a policy is a new sale for whoever recommended it, and several provinces require a replacement declaration precisely because of the risks. Read replacing an existing policy before doing anything.

The rule that prevents the worst outcome

Never surrender existing coverage until any replacement is issued, delivered and in force.

Underwriting can come back with a rating you did not expect, or a decline. Someone who cancels first and applies second can end up with no coverage at all, at an older age and in whatever health they are now in. That mistake is not recoverable.

Before you sign anything

Ask the insurer for the current cash surrender value, the current adjusted cost basis, the projected taxable gain on surrender, the reduced paid-up amount available, and the premium if the face amount were reduced.

All five are figures the insurer can produce. With them in front of you the decision is usually obvious, and it is frequently not the one you called to make.