Do You Pay Taxes on a Life Insurance Policy?

Life insurance is a contract between a policyholder and an insurer, designed to provide financial protection to beneficiaries upon the insured’s death. Policyholders make regular premium payments in exchange for a death benefit. Understanding the tax implications of life insurance policies is important, as while many assume benefits are entirely tax-free, certain circumstances can lead to tax obligations.

Taxation of Death Benefit Proceeds

Life insurance death benefits paid to a named beneficiary are generally not subject to federal income tax. This rule applies whether the policy is a term life or a permanent life insurance plan. The Internal Revenue Service (IRS) typically does not consider these proceeds as gross income, meaning beneficiaries usually do not need to report them.

However, if a beneficiary chooses to receive the death benefit in installments rather than a lump sum, any interest earned on the held proceeds becomes taxable income. This interest must be reported by the beneficiary.

The “transfer-for-value” rule applies if a life insurance policy is sold or transferred for valuable consideration. When this occurs, the death benefit may become partially or fully taxable to the transferee. The taxable amount is generally the death benefit minus the consideration paid for the policy and any subsequent premiums paid by the new policy owner.

Exceptions to the transfer-for-value rule allow the death benefit to remain income tax-free. These include transfers to:
The insured
A partner of the insured
A partnership in which the insured is a partner
A corporation in which the insured is a shareholder

Consulting with a tax advisor is advisable when considering such transfers.

Employer-provided group term life insurance can have tax implications for the employee. If coverage provided by an employer exceeds $50,000, the cost above that amount, less any premiums paid by the employee, may be considered taxable income to the employee. However, the death benefit itself generally remains income tax-free to the beneficiary.

Taxation of Policy Cash Value and Distributions

Permanent life insurance policies, such as whole life or universal life, accumulate a cash value that grows on a tax-deferred basis. Policyholders do not pay taxes on annual gains as long as the money remains within the policy.

Policyholders can access the accumulated cash value through withdrawals or loans. Withdrawals are generally treated on a “first-in, first-out” (FIFO) basis. Amounts withdrawn up to the total premiums paid into the policy (the cost basis) are typically considered a tax-free return of principal. However, any amounts withdrawn that exceed this cost basis are considered taxable income, taxed as ordinary income.

Loans taken against the cash value are generally tax-free because they are considered a debt against the policy, not a distribution. The policy must remain in force for the loan to retain its tax-free status. If the policy lapses or is surrendered with an outstanding loan, the untaxed portion of the loan exceeding the policy’s cost basis can become taxable income to the policyholder, as it is treated as a distribution upon termination.

If a permanent life insurance policy is surrendered, any amount received that exceeds the total premiums paid (the cost basis) is considered taxable income. This gain is taxed as ordinary income, not capital gains. Surrender charges can also reduce the amount received.

Policyholders can exchange one life insurance policy for another without immediate tax consequences through a “1035 exchange,” governed by Internal Revenue Code Section 1035. This allows for the tax-deferred transfer of accumulated gains from an old policy to a new one, provided specific IRS rules are followed:
The exchange must be from one life insurance policy to another life insurance policy, or from a life insurance policy to an annuity or qualified long-term care policy.
Funds cannot be received directly by the policyholder during the exchange.

Life Insurance and Estate Taxation

Estate tax is a separate federal tax levied on the total value of a deceased person’s assets before distribution to heirs. This tax is distinct from income tax. The federal estate tax exemption is $13.99 million per individual for 2025, meaning most estates are not subject to this tax. Estates exceeding this threshold may incur federal estate tax on the value above the exemption.

Life insurance proceeds can be included in the taxable estate if the deceased individual owned the policy at the time of their death or retained “incidents of ownership.” Incidents of ownership refer to any economic control over the policy, such as the right to:
Change beneficiaries
Surrender or cancel the policy
Assign the policy
Borrow against its cash value

Retaining these rights can lead to the proceeds being included in the estate, even if someone else holds legal title.

The “three-year rule” is another relevant estate taxation rule. If a life insurance policy is transferred out of the insured’s ownership within three years of their death, the proceeds may still be included in their taxable estate. This rule prevents last-minute transfers to avoid estate taxes. To avoid it, the policy should ideally be applied for and initially owned by the new owner, such as a trust, rather than being transferred from the insured.

Irrevocable Life Insurance Trusts (ILITs) are a strategy used to remove life insurance proceeds from the taxable estate. An ILIT is an irrevocable trust that owns the life insurance policy, removing it from the insured’s direct ownership. When an ILIT owns the policy, the death benefits are generally not considered part of the insured’s estate upon death, provided the trust is properly established and maintained, and the three-year rule is navigated successfully.

By transferring ownership to an ILIT, policy proceeds bypass the insured’s probate estate and are not subject to estate taxes, providing liquidity to heirs without increasing the taxable estate. Establishing and maintaining an ILIT involves legal complexities, requiring correct structuring to achieve the desired estate tax benefits.