Is Life Insurance Taxable? An Overview of Tax Rules

Life insurance provides a financial benefit to designated beneficiaries upon the insured’s death, offering financial protection and security. While its core function is straightforward, its tax implications can be intricate. Understanding how various aspects of a life insurance policy are treated under tax law is important for both policyholders and beneficiaries. This article clarifies the tax consequences associated with life insurance death benefits, cash value accumulation, policy loans and withdrawals, and estate or gift taxes.

Taxation of Life Insurance Death Benefits

Life insurance death benefits are generally received by beneficiaries free from federal income tax. This means that when a lump sum payment is made, beneficiaries typically do not owe income tax on the amount received. This income tax exclusion applies to both term and permanent life insurance policies.

However, certain situations can lead to taxation. If the death benefit earns interest while held by the insurer, any accrued interest becomes taxable income to the beneficiary. For example, if a beneficiary chooses installment payouts, the interest component is subject to income tax.

Another exception is the “transfer-for-value rule,” defined in U.S. tax code IRC Section 101. If a policy or an interest in it is transferred for valuable consideration, a portion of the death benefit may become taxable. The taxable amount is the death benefit minus the consideration paid for the policy and any subsequent premiums paid by the new owner. This rule aims to prevent tax-free windfalls from the sale of policies. Exceptions include transfers to the insured, a partner of the insured, or a partnership in which the insured is a partner.

Employer-provided group term life insurance also has tax implications. While the death benefit is generally tax-free, employer-paid premiums for coverage exceeding $50,000 may be considered taxable income to the employee during their lifetime.

Taxation of Life Insurance Cash Value

Certain life insurance policies, such as whole life and universal life, include a cash value component that accumulates over time. This cash value grows on a tax-deferred basis, meaning earnings are not subject to income tax as they accumulate, allowing for potentially faster growth.

When a policy is surrendered for its cash value, any amount received exceeding the policy’s “cost basis” is subject to ordinary income tax. The cost basis is the total premiums paid into the policy, less any prior untaxed distributions. For instance, if a policyholder paid $20,000 in premiums and the cash surrender value is $30,000, the $10,000 gain is taxable. The insurer may issue a Form 1099-R if the cash surrender value exceeds premiums paid.

Policy dividends are generally not taxable income until the total dividends received exceed the cumulative premiums paid. If dividends exceed the total premiums paid, the excess is considered taxable income. For example, if a policyholder pays $1,000 in premiums and receives a $1,250 dividend, the $250 excess may be taxable. If dividends accumulate interest within the policy, the interest earned may be taxable.

Taxation of Policy Loans and Withdrawals

Policy loans and withdrawals from a life insurance policy’s cash value have distinct tax treatments. A loan taken against the cash value of a permanent life insurance policy is generally not considered taxable income, as it is treated as a debt against the policy’s value. This non-taxable status applies as long as the policy remains in force. There is no mandatory repayment schedule, and the outstanding loan amount is typically deducted from the death benefit if not repaid.

However, a policy loan can become taxable if the policy lapses or is surrendered while the loan is outstanding. In such a scenario, the loan amount exceeding the policy’s cost basis can be considered taxable income. This can result in unexpected tax liabilities, especially if the policy’s cash value has grown significantly.

Withdrawals from a policy’s cash value are generally treated on a “first-in, first-out” (FIFO) basis for tax purposes. This means withdrawals are first considered a return of the premiums paid (the cost basis) and are not taxable until the total withdrawals exceed this cost basis. Once the accumulated withdrawals surpass the cost basis, any subsequent withdrawals are taxed as ordinary income. Withdrawals differ from surrendering the entire policy, which terminates coverage completely.

Life Insurance and Estate or Gift Taxes

Life insurance proceeds, while generally income tax-free for beneficiaries, can be subject to federal estate taxes. If the insured owned the policy at death, or held “incidents of ownership” like the right to change beneficiaries or borrow against the policy, the death benefit is usually included in their taxable estate. This inclusion can increase the estate’s value, potentially subjecting it to estate tax if it exceeds the federal exemption threshold.

A common strategy to remove life insurance proceeds from the taxable estate is to transfer policy ownership to an irrevocable life insurance trust (ILIT). An ILIT is an irrevocable trust that owns the policy, removing it from the insured’s personal estate. For exclusion from the estate, the insured must survive at least three years after transferring an existing policy to the ILIT. If the insured dies within this three-year period, the policy proceeds may still be included in their taxable estate.

Gifting a life insurance policy to another individual can also have gift tax implications. The cash value of a gifted policy, or premiums paid by the donor to maintain a policy owned by another, can be considered a taxable gift. These gifts are subject to annual gift tax exclusions. For 2025, the annual gift tax exclusion is $19,000 per recipient, meaning an individual can give up to this amount to any number of people without triggering gift tax reporting requirements. Married couples can combine their exclusions, allowing a gift of $38,000 per recipient in 2025. If a gift exceeds this annual exclusion, it reduces the donor’s lifetime gift tax exemption.