I'm not a CPA, but a whole life insurance holder so I have done some research on things like this...... someone else should confirm, but you should make sure that a basis is tracked in relation to your surrender (may reduce amount of tax you owe).
If I understand correctly, all premiums paid count as a basis that is subtracted from the amount cashed out to determine how much is subject to tax. And then it should be taxed at your general income tax rate I believe. I would imagine any penalty might be related to a tax underpayment if you didn't pay tax on the proceeds of the cash out and/or you have lots of proceeds (either in reality or due to untracked basis).
I haven't cashed out my own life insurance policy yet and have been debating doing so. So I'd really love to know what a true expert has to say on this.
