Does Life Insurance Get Taxed? Key Tax Scenarios

Life insurance provides a financial safety net for beneficiaries upon the insured’s passing. While many perceive life insurance payouts as entirely tax-free, various scenarios can trigger tax liabilities. Understanding these potential tax implications is important for policyholders and beneficiaries to effectively manage financial outcomes. The tax treatment of life insurance depends on how the policy is structured and how benefits are received.

Taxation of Death Benefits

Life insurance death benefits are generally received by beneficiaries free of federal income tax. This tax-free treatment applies to lump sum payments from most life insurance policies. However, if the death benefit is paid out in installments, any interest accrued on the principal amount will be considered taxable income for the beneficiary.

An exception to the income tax-free rule for death benefits 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, meaning it was sold or exchanged for something of value. If this rule is triggered, the death benefit may become partially or fully taxable to the recipient. The taxable amount is the death benefit minus the consideration paid for the policy and any subsequent premiums paid by the new owner.

The transfer for value rule aims to prevent individuals from profiting from the tax-free status of life insurance by purchasing policies solely for their death benefits. However, several exceptions allow the death benefit to remain tax-free. These include transfers to the insured, 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.

Taxation of Living Benefits

Life insurance policies that accumulate cash value, such as whole life or universal life, offer living benefits with distinct tax implications. The growth of the cash value within these policies is on a tax-deferred basis, meaning taxes are not due on the earnings until the money is accessed. This tax deferral allows the cash value to compound over time.

Policyholders can access the accumulated cash value through withdrawals or policy loans. When making withdrawals, the IRS treats these transactions on a “first-in, first-out” (FIFO) basis. The amount withdrawn is first considered a return of the premiums paid (the policyholder’s “basis”), which is received tax-free. Once withdrawals exceed the total premiums paid, any additional amounts withdrawn are considered taxable income, as they represent the policy’s investment gains. Withdrawals can also reduce the policy’s death benefit.

Policy loans, in contrast to withdrawals, are income tax-free because they are considered debt against the policy’s cash value, not distributions of income. The policyholder is borrowing their own money, with the cash value serving as collateral. However, if a policy with an outstanding loan lapses or is surrendered, the unpaid loan amount that exceeds the policyholder’s basis can become taxable income. This can create a “phantom income” scenario where tax is owed even if no cash was received at the time of lapse.

Dividends paid by mutual life insurance companies to policyholders are not taxable, as they are considered a return of excess premiums paid. This tax-free status holds as long as cumulative dividends received do not exceed the total premiums paid into the policy. If dividends, when combined with other distributions, exceed the policyholder’s total premiums paid, the excess amount becomes taxable income. Any interest earned on dividends left with the insurer to accumulate will also be subject to income tax.

Taxation of Policy Surrender

When a life insurance policy with cash value is surrendered, the policyholder receives the accumulated cash value, minus any surrender charges or outstanding loans. The tax consequences depend on the relationship between the cash surrender value received and the policyholder’s cost basis. The cost basis is defined as the total amount of premiums paid into the policy, reduced by any tax-free withdrawals or dividends previously received.

Any amount received upon surrender that exceeds this cost basis is considered a taxable gain. This gain is treated as ordinary income and is subject to the policyholder’s regular income tax rate, not capital gains rates. For example, if a policyholder paid $20,000 in premiums and receives $30,000 upon surrender, the $10,000 difference is taxable income. If the surrender value is less than or equal to the premiums paid, there is no taxable gain.

While the return of premiums paid is tax-free as a return of principal, any earnings above that amount are subject to taxation. If outstanding policy loans exist when the policy is surrendered, the loan amount will be deducted from the cash surrender value, and any portion of the loan exceeding the basis can also be subject to tax. Consulting with a tax professional before surrendering a policy is advisable to understand the tax impact and explore alternatives.

Estate and Gift Tax Considerations

Life insurance proceeds can be subject to estate tax, a tax on the right to transfer property at death, distinct from income tax. Under Internal Revenue Code Section 2042, life insurance death benefits are included in the deceased insured’s taxable estate if the proceeds are payable to the estate, or if the insured retained “incidents of ownership” in the policy at the time of death. Incidents of ownership refer to various rights over the policy, such as the ability to change beneficiaries, borrow against the cash value, or cancel the policy. Even minor rights can trigger inclusion in the taxable estate.

For 2025, the federal estate tax exemption is $13.99 million per individual. If an individual’s total estate value, including life insurance proceeds where incidents of ownership were retained, exceeds this threshold, the excess amount may be subject to federal estate tax. If a policy is transferred to another owner, but the insured dies within three years of the transfer, the death benefit may still be included in the insured’s taxable estate under the “three-year rule”.

To avoid the inclusion of life insurance proceeds in the taxable estate, some individuals establish an Irrevocable Life Insurance Trust (ILIT). An ILIT is an irrevocable trust designed to own life insurance policies, removing them from the insured’s personal estate. When the ILIT owns the policy, the death benefit is paid directly to the trust, which then distributes the funds according to the trust’s terms, bypassing the insured’s probate estate and potentially avoiding estate taxes. This strategy can provide liquidity for heirs to cover estate taxes without forcing the sale of other assets.

Gifting a life insurance policy, or the funds to pay premiums, can also have gift tax implications if the value transferred exceeds certain limits. For 2025, the annual gift tax exclusion allows an individual to give up to $19,000 to any number of recipients without triggering gift tax reporting requirements. Married couples can combine their exclusions to gift up to $38,000 per recipient. If the value of the gifted policy or the premium payments exceeds this annual exclusion, the excess amount will reduce the donor’s lifetime gift tax exemption, which is tied to the estate tax exemption. Exceeding the annual exclusion requires filing a gift tax return (IRS Form 709).