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

Life insurance serves as a financial tool designed to provide a monetary benefit to beneficiaries upon the insured’s passing. While many benefits are tax-free, certain transactions and circumstances can trigger tax obligations. Understanding these nuances is important for policyholders and beneficiaries. Navigating the tax landscape of life insurance helps ensure that financial planning aligns with expected outcomes.

Taxation of Death Benefits

The death benefit from a life insurance policy is generally received by beneficiaries free from federal income tax. This exclusion applies to all forms of life insurance. This tax treatment provides financial support to surviving family members without an additional tax burden.

However, certain situations can lead to tax implications for death benefit proceeds. If beneficiaries choose to receive the death benefit in installments rather than a single lump sum, any interest earned on the held proceeds becomes taxable as ordinary income. The original death benefit amount remains tax-free, but the interest component is subject to taxation.

Life insurance proceeds can also be subject to federal estate tax if the policy is included in the deceased’s taxable estate and exceeds the federal estate tax exemption limit. For 2025, this exemption is $13.99 million for individuals. Only the portion of the estate exceeding this amount is subject to the tax, which can reach a maximum rate of 40 percent.

Another exception to the tax-free death benefit is the transfer-for-value rule, outlined in U.S. tax code Section 101. If a life insurance policy is sold or transferred for valuable consideration, the death benefit may become partially or fully taxable to the recipient. The taxable amount is generally the death benefit minus the consideration paid for the policy and any subsequent premiums paid by the new owner.

Taxation of Cash Value

Permanent life insurance policies, such as whole life or universal life, include a cash value component that accumulates over time. This cash value grows on a tax-deferred basis, meaning policyholders do not pay taxes on annual gains as they accumulate within the policy. This tax deferral allows the cash value to compound more efficiently.

Accessing the accumulated cash value can have varying tax consequences depending on the method used. When a policyholder makes withdrawals, these are generally treated under the “first-in, first-out” (FIFO) rule for non-Modified Endowment Contracts (MECs). Under FIFO, withdrawals are considered a return of the premiums paid (cost basis) first, and this portion is tax-free. Once the total withdrawals exceed the premiums paid, any additional amounts withdrawn are considered taxable gains and are taxed as ordinary income.

Policy loans are another way to access cash value, and they are generally not considered taxable income as they are treated as debt against the policy. However, a tax liability can arise if the policy lapses or is surrendered with an outstanding loan. In such cases, the outstanding loan amount, to the extent it exceeds the policy’s cost basis, can become taxable as ordinary income. This can result in a tax bill even if the policyholder receives little to no cash from the surrender.

Surrendering a policy for its cash value also has specific tax implications. If the amount received upon surrender exceeds the total premiums paid into the policy (the cost basis), the excess amount is considered a taxable gain. This gain is taxed as ordinary income at the policyholder’s applicable income tax rate. Surrender charges, which can be substantial, reduce the amount received but do not change the calculation of the taxable gain.

Other Policy Transactions and Taxation

Dividends from participating life insurance policies are considered a return of premiums paid and are generally not taxable. This tax-free treatment applies as long as the cumulative dividends received do not exceed the total premiums paid into the policy. If the dividends received surpass the total premiums paid, the excess amount becomes taxable as ordinary income.

Accelerated death benefits, also known as living benefits, allow a policyholder to access a portion of their death benefit while still alive, often due to chronic or terminal illness. Payments received under an accelerated death benefit rider are generally tax-free if specific conditions are met, such as a physician certifying a terminal illness or a chronic illness requiring qualified long-term care services. If the medical condition does not meet the IRS definition of terminal or chronic illness, or if payments for chronic illness exceed certain per diem limits, the benefits may become taxable.

A life settlement involves selling an existing life insurance policy to a third party for a cash amount greater than the policy’s cash surrender value but less than the death benefit. The tax treatment of life settlement proceeds is multi-layered. The portion of the proceeds up to the policy’s cost basis is received tax-free. The amount between the cost basis and the cash surrender value is taxed as ordinary income. Any amount received above the cash surrender value is taxed as a capital gain.

Tax Reporting and Policy Considerations

For any taxable events related to a life insurance policy, the insurance company is required to report the distribution to the Internal Revenue Service (IRS). This reporting is done using Form 1099-R, “Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.” This form details the gross distribution and the taxable portion, which is then used by the policyholder or beneficiary for their income tax filing.

Given the complexities involved in life insurance taxation, particularly with cash value transactions, policyholders and beneficiaries often benefit from consulting with a qualified tax advisor or financial planner. These professionals can provide guidance, clarify tax implications, and assist with proper tax reporting. Maintaining accurate records of all premiums paid and policy transactions is important for determining cost basis and calculating taxable gains.