Do I Have to Pay Taxes on a Life Insurance Policy?

Life insurance policies are financial contracts designed to provide a financial safety net for beneficiaries upon the insured’s passing. While many people assume that life insurance proceeds are always free from taxation, various situations can lead to tax implications. Understanding these scenarios is important for both policyholders and beneficiaries to effectively manage their financial planning.

Death Benefit Taxation

Life insurance death benefits paid to beneficiaries are generally not subject to income tax. This applies when the beneficiary receives the payout as a lump sum.

An important exception to this general rule is the “transfer-for-value rule.” If a life insurance policy is transferred from one owner to another for valuable consideration, a portion of the death benefit may become taxable. For example, if a policy originally owned by an individual is sold to a third party, the death benefit exceeding the sum of the purchase price and any subsequent premiums paid by the new owner could be subject to income tax.

If beneficiaries choose to receive the death benefit in installments rather than a lump sum, any interest earned on the unpaid portion is typically taxable. While the original death benefit remains tax-free, this additional interest income is subject to ordinary income tax. Similarly, if a policyholder is also the beneficiary, such as in certain business-owned life insurance arrangements, the death benefit may be treated differently for tax purposes, often becoming taxable if the policy was transferred for value.

Living Benefit Taxation

Accessing funds from a life insurance policy during the policyholder’s lifetime involves several distinct tax considerations. Permanent life insurance policies, such as whole life or universal life, accumulate cash value over time. This cash value grows on a tax-deferred basis, meaning that the earnings are not taxed as they accrue within the policy.

Withdrawals from a policy’s cash value are generally treated on a “first-in, first-out” (FIFO) basis for tax purposes. This means that amounts withdrawn up to the total premiums paid into the policy, which is considered the cost basis, are tax-free. Once the withdrawals exceed the cost basis, any additional amounts are considered taxable income.

Policy loans taken against the cash value are typically not considered taxable income, as they are viewed as debt rather than a distribution of earnings. However, if the policy lapses or is surrendered with an outstanding loan, the loan amount exceeding the cost basis can become taxable. The interest charged on policy loans is generally not tax-deductible.

Dividends received from a participating life insurance policy are generally treated as a return of premium and are tax-free, unless they exceed the total premiums paid into the policy. If dividends are used to purchase paid-up additions or are left to accumulate interest within the policy, any interest earned on those dividends becomes taxable.

A Modified Endowment Contract (MEC) is a cash value life insurance policy that loses tax advantages by exceeding federal premium limits (the “seven-pay test”). MEC withdrawals, loans, and dividends are taxed differently. They are treated on a “last-in, first-out” (LIFO) basis, taxing earnings first. A 10% penalty may apply to taxable withdrawals or loans if the policyholder is under age 59½.

Taxation of Policy Sales

Selling a life insurance policy to a third party, rather than surrendering it to the insurer, can also have tax implications. This often occurs through a “viatical settlement” for terminally ill individuals or a “life settlement” for chronically ill or elderly individuals.

Proceeds from a viatical settlement are generally tax-free if the policyholder is certified by a physician as terminally ill (typically with a life expectancy of 24 months or less) or chronically ill, provided the funds are used for qualified long-term care expenses.

For life settlements, which involve selling a policy when the insured is not terminally ill, the proceeds are typically taxable. The taxable amount is determined by comparing the sale proceeds to the policy’s cost basis (total premiums paid minus any tax-free withdrawals received); the portion up to this cost basis is tax-free. Any amount received above the cost basis but up to the policy’s cash surrender value is taxed as ordinary income. Any remaining proceeds exceeding the cash surrender value are taxed as capital gains.

Estate Tax Implications

While life insurance death benefits are generally income tax-free for beneficiaries, they can be included in the deceased’s taxable estate for federal estate tax purposes under specific conditions. This occurs if the policyholder retained “incidents of ownership” over the policy at the time of their death. Incidents of ownership include the right to change beneficiaries, surrender or cancel the policy, borrow against its cash value, or assign the policy.

If the deceased held such rights, the full death benefit might be added to their gross estate, potentially subjecting it to estate taxes if the total estate value exceeds the federal estate tax exemption limit. For 2025, this exemption is $13.99 million per individual. Since estate taxes apply only to very large estates, most individuals and their beneficiaries are not impacted by this.

To remove life insurance proceeds from the taxable estate, policyholders sometimes transfer ownership of the policy to an irrevocable life insurance trust (ILIT). This trust becomes the owner and beneficiary of the policy, effectively removing it from the insured’s estate. However, for the transfer to be effective for estate tax purposes, the insured must survive for at least three years after transferring the policy to the ILIT.