IRC 101: Tax Rules for Life Insurance and Death Benefits

Life insurance plays a key role in financial planning, providing beneficiaries with financial support after the policyholder’s death. However, the tax treatment of life insurance proceeds depends on factors like ownership, payout structure, and policy type. Understanding these rules helps avoid unexpected tax liabilities.

The Internal Revenue Code (IRC) governs how life insurance benefits are taxed. While many payouts are tax-free, exceptions exist based on policy structure or transfer. This article examines key tax rules, exclusions, and potential tax implications.

General Exclusion for Life Insurance Proceeds

Life insurance proceeds are generally not subject to federal income tax when paid as a lump sum to a beneficiary. IRC Section 101(a)(1) states that amounts received under a life insurance contract due to the insured’s death are not included in gross income. This applies regardless of policy size, ensuring beneficiaries receive the full benefit without income tax deductions.

If the death benefit is paid in installments, any interest earned on those payments is taxable. For example, if a $500,000 policy is paid out over ten years with an additional $50,000 in interest, the original death benefit remains tax-free, but the $50,000 in interest must be reported as taxable income.

Policy ownership can also affect taxation. If the insured owns the policy at death, the proceeds are excluded from income tax but may be included in the insured’s estate for estate tax purposes if the total estate value exceeds the federal exemption limit of $13.61 million for 2024. To avoid this, some individuals transfer ownership to an irrevocable life insurance trust (ILIT), removing the policy from their taxable estate while preserving the income tax exclusion for beneficiaries.

Accelerated Death Benefits

When a policyholder is diagnosed with a terminal or severe chronic illness, they may access a portion of their life insurance payout before death through an accelerated death benefit (ADB). The amount received through an ADB is deducted from the final death benefit.

Under IRC Section 101(g), ADBs are generally tax-free if the insured meets medical criteria. A physician must certify that the insured is terminally ill, meaning they have a life expectancy of 24 months or less, or chronically ill and unable to perform at least two activities of daily living (ADLs) without assistance. ADLs include essential functions such as eating, bathing, and dressing. For chronically ill individuals, tax-free treatment applies only if the funds are used for qualified long-term care expenses.

Insurance companies may cap how much can be accessed through an ADB, often allowing up to 50% of the total death benefit. For example, if a policy has a $500,000 death benefit and the insurer permits a 50% ADB, the insured could receive up to $250,000 while still alive, leaving the remaining $250,000 for beneficiaries.

ADB payments can also affect Medicaid eligibility. These payments are considered an available asset when determining Medicaid qualification, which could impact eligibility for government assistance if the funds are not spent on medical or care-related expenses.

Transfer for Value Rules

Life insurance proceeds are usually tax-free, but that changes if the policy is transferred for something of value before the insured’s death. IRC Section 101(a)(2), known as the Transfer for Value Rule, states that if a life insurance policy is sold or transferred in exchange for money, property, or services, the death benefit loses its full tax-exempt status. The payout becomes taxable to the extent it exceeds the new owner’s investment in the contract.

This rule prevents life insurance from being used as a trading asset where investors buy policies to profit from the death benefit. However, exceptions exist. If the policy is transferred 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, the tax-free treatment remains intact.

A common scenario where this rule applies is life settlement transactions. In a life settlement, a policyholder sells their life insurance to a third-party investor for a lump sum, typically receiving more than the cash surrender value but less than the full death benefit. The buyer continues paying premiums and collects the death benefit when the insured passes away. While this provides liquidity for the seller, the investor may face taxation on a portion of the payout due to the Transfer for Value Rule.

Employer-Owned Life Insurance

Businesses often take out life insurance policies on key employees to mitigate financial risks associated with their unexpected passing. These employer-owned life insurance (EOLI) policies, sometimes called corporate-owned life insurance (COLI), provide the company with a death benefit to cover lost revenue, recruitment costs, or debt obligations. The tax treatment of EOLI is subject to compliance requirements under IRC Section 101(j) to prevent abuse and ensure transparency.

For an employer to receive the death benefit tax-free, the insured employee must have been notified in writing and provided consent before the policy was issued. Additionally, the business must meet one of the exceptions under Section 101(j)(2), which generally require that the insured was either a highly compensated employee (earning at least $135,000 in 2024) or held a significant ownership or management role at the company. If these conditions are not met, the death proceeds become partially or fully taxable.

Businesses must also comply with IRS reporting requirements, including filing Form 8925 (Report of Employer-Owned Life Insurance Contracts) annually to disclose the number of policies and total benefits in force. Failure to meet these documentation obligations can result in unexpected tax liabilities.

Policy Surrenders or Terminations

When a life insurance policy is surrendered or terminated before the insured’s death, taxation depends on how much has been paid into the policy and whether any gains have accumulated. If the policyholder cancels the contract and receives a cash surrender value, the amount received is taxable to the extent it exceeds the total premiums paid, known as the cost basis. For example, if $50,000 in premiums were paid into a policy and the surrender value is $70,000, the $20,000 gain is subject to ordinary income tax.

If a policy lapses due to nonpayment of premiums, there may be no immediate tax consequences unless the policy had an outstanding loan. If a loan balance exceeds the remaining cash value at termination, the difference is treated as taxable income. This often surprises policyholders who have borrowed against their policies, as they may face an unexpected tax bill even though they did not receive an actual cash payout. Proper planning, such as repaying loans or utilizing 1035 exchanges, can help avoid these tax implications.

Interactions with Estate and Gift Tax

Life insurance can have significant estate and gift tax implications, particularly for high-net-worth individuals. While death benefits are excluded from income tax, they may be subject to federal estate tax if the insured owns the policy at the time of death. The IRS considers any policy owned by the decedent within three years of death as part of their taxable estate under the “three-year rule” in IRC Section 2035. If an individual transfers ownership of their policy but dies within three years, the proceeds are still included in their estate.

To avoid estate tax exposure, many individuals use irrevocable life insurance trusts (ILITs) to hold policies outside of their estate. By transferring ownership to an ILIT, the insured relinquishes control, preventing the death benefit from being counted toward their taxable estate. However, improper structuring can still trigger estate inclusion. Additionally, gifting a policy to another individual or trust may result in gift tax consequences if the policy’s value exceeds the annual gift tax exclusion, which is $18,000 per recipient in 2024. Strategic planning, such as using the lifetime gift tax exemption, can help mitigate these tax burdens.