Do You Pay Taxes on Life Insurance Money?

Life insurance payouts are often misunderstood regarding their tax treatment. While many aspects offer significant tax advantages, certain situations can trigger tax liabilities. Understanding these nuances is important for policyholders and beneficiaries.

Taxation of Death Benefit Proceeds

Life insurance death benefits generally receive favorable tax treatment. Amounts received by a beneficiary due to the insured’s death are excluded from federal income tax under Internal Revenue Code Section 101. This means a lump-sum payment is usually not subject to income tax.

However, the income tax-free status of death benefits has specific exceptions. If the beneficiary opts to receive the death benefit in installments rather than a single sum, any interest earned on the proceeds while held by the insurer becomes taxable as ordinary income. For example, if the insurance company holds the principal and pays out interest over time, that interest component is subject to income tax.

Another exception is the “transfer-for-value” rule, outlined in Internal Revenue Code Section 101. This rule applies when a life insurance policy is transferred for valuable consideration. In such cases, the death benefit may become taxable to the recipient, limited to the consideration paid for the policy plus any subsequent premiums.

Specific exceptions to the transfer-for-value rule allow the death benefit to retain its income tax-free status. These “safe harbor” transfers include those made to the insured person, a partner of the insured, a partnership in which the insured is a partner, or a corporation in which the insured is a shareholder or officer. For instance, if a business partner buys a policy from another partner, the death benefit would still be income tax-free.

Accelerated death benefits, which allow terminally or chronically ill individuals to access a portion of their death benefit while still living, are generally tax-free. Internal Revenue Code Section 101 provides that these amounts are excluded from gross income. A terminally ill individual is typically certified by a physician as having an illness expected to result in death within 24 months or less.

Taxation of Cash Value

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 the policyholder does not pay taxes on the annual gains as they accumulate within the policy.

Accessing the cash value through withdrawals has specific tax implications. Withdrawals are generally treated on a first-in, first-out (FIFO) basis. Amounts withdrawn up to the total premiums paid into the policy (known as the cost basis) are considered a return of principal and are typically tax-free. Once withdrawals exceed the total premiums paid, any additional amounts are considered taxable income.

Policy loans are another way to access cash value and are generally tax-free, provided the policy remains in force. The policyholder borrows against the cash value, and the loan does not constitute a distribution of income. However, if the policy lapses or is surrendered with an outstanding loan, the loan amount exceeding the policy’s cost basis can become taxable as ordinary income.

Surrendering a policy for its cash value can also trigger a tax event. If the cash surrender value received exceeds the total premiums paid into the policy, the difference is considered a taxable gain. This gain is taxed as ordinary income in the year the policy is surrendered.

A Modified Endowment Contract (MEC) has less favorable tax treatment for withdrawals and loans. A policy becomes an MEC if it fails the “7-pay test” under Internal Revenue Code Section 7702A, which limits the premium amount that can be paid into a policy within its first seven years. Loans and withdrawals from MECs are taxed on a last-in, first-out (LIFO) basis, meaning gains are taxed first. Additionally, withdrawals or loans from an MEC before age 59½ may be subject to a 10% penalty tax, in addition to ordinary income tax.

Taxation of Life Insurance Dividends

Dividends from participating life insurance policies are generally considered a return of a portion of the premium paid. They are not taxable income until the total dividends received exceed the cumulative premiums paid into the policy. If cumulative dividends exceed total premiums paid, any excess amount becomes taxable as ordinary income.

Policyholders have several options for how to use their dividends:
Receive them as cash.
Use them to reduce future premium payments.
Use them to purchase paid-up additional insurance coverage.
Leave them with the insurer to accumulate interest.

While dividends may be non-taxable up to the premium basis, any interest earned on accumulated dividends is always taxable in the year it is credited or received.

Estate Tax Implications

Life insurance proceeds can have implications for federal estate taxes, which are distinct from income taxes. Proceeds may be included in the deceased’s gross estate if the deceased owned the policy at the time of death or retained any “incidents of ownership” over it.

Incidents of ownership refer to the right to control the policy’s economic benefits. Examples include the right to change beneficiaries, surrender or cancel the policy, assign the policy, pledge it for a loan, or borrow against its cash value.

Federal estate tax generally applies only to estates exceeding a certain exemption amount. For individuals dying in 2025, the federal estate tax exemption is $13.99 million. State estate taxes may have different exemption amounts and rules.

One common strategy to exclude life insurance proceeds from the taxable estate is to establish an Irrevocable Life Insurance Trust (ILIT). When an ILIT owns the policy, the insured individual does not retain any incidents of ownership. This arrangement removes the death benefit from the insured’s taxable estate, helping to reduce potential estate tax liability for beneficiaries.