Policy gain is the taxable amount that may arise when a life insurance policy is surrendered, partially surrendered, lapsed with value, or otherwise disposed of in a manner that triggers recognition of income under the tax code. For most individually owned policies, policy gain is calculated as the excess of the policy's cash surrender value or amount realized over the owner's tax basis, generally the total premiums paid minus prior non-taxable distributions. When a policy loan is outstanding and the contract is surrendered or lapses, the outstanding loan is treated as part of the amount realized, potentially creating policy gain even when no cash is received. Policy gain is typically taxed as ordinary income rather than capital gain. While death benefits generally remain income-tax free under Section 101 when paid to individuals, policy gain can surprise clients who terminate or restructure policies without understanding tax consequences.

In everyday planning and servicing, advisors encounter policy gain when clients consider surrendering underperforming policies, executing 1035 exchanges, restructuring coverage or failing to maintain policies that later lapse with loans. Advanced planning teams and CPAs often run projections showing potential policy gain under different exit scenarios, highlighting how outstanding loans or large cash values relative to basis can create taxable events. When a 1035 exchange is available and suitable, it can allow policy values to move into a new contract without current recognition of gain, preserving tax deferral. In other cases, clients may choose to spread recognition of policy gain over time through structured withdrawals or partial surrenders, or accept a one-time tax hit as part of broader planning goals. Properly documenting and explaining policy gain helps clients make informed decisions and avoids unpleasant surprises when Form 1099-R arrives after a surrender, lapse with loan or policy sale transaction.