Is Life Insurance Taxable in Illinois? Tax Rules You Should Know

Life insurance provides financial protection for beneficiaries, but many people are unsure how taxes apply to payouts and policy features. Illinois generally follows federal tax guidelines, though some state-specific considerations may affect taxation. Understanding these rules helps avoid unexpected liabilities.

Death Benefit and Income Tax Factors

Life insurance death benefits are typically not subject to federal or Illinois state income tax when paid as a lump sum to a named beneficiary. If a policyholder in Illinois passes away and their beneficiary receives a $500,000 payout, they do not need to report it as taxable income. The IRS classifies these proceeds as non-taxable under Section 101(a) of the Internal Revenue Code, provided they are received as a direct death benefit rather than through certain settlement options.

If the payout is structured as an annuity or installment payments, any interest earned on the remaining balance is taxable. For example, if a beneficiary receives $50,000 annually over ten years instead of a single $500,000 payment, the portion representing the original death benefit remains tax-free, but interest accrued on the unpaid balance is subject to income tax. The insurance company will issue a Form 1099-INT to report the taxable portion.

Employer-provided group life insurance can introduce additional tax considerations. The first $50,000 of coverage provided by an employer is tax-free, but any amount above this threshold is considered imputed income and subject to taxation. If an employer provides $200,000 in coverage, the taxable portion is based on the cost of the excess $150,000, calculated using IRS Table I rates. Employees may see this added to their W-2 as taxable income.

Possible Estate Tax Responsibilities

Life insurance proceeds may be included in a taxable estate if the policyholder retains ownership rights at death. Illinois does not impose a state-level estate tax as of 2024, but federal estate tax rules still apply. If an estate, including life insurance proceeds, exceeds the federal exemption limit—$13.61 million for individuals in 2024—any amount above this threshold is subject to a 40% federal estate tax. For example, if an estate is worth $15 million, the taxable portion would be $1.39 million, resulting in a potential tax liability of $556,000.

Ownership determines whether life insurance proceeds are included in an estate. If the policyholder retains control—such as the ability to change beneficiaries, borrow against the policy, or cancel coverage—the IRS considers the death benefit part of the taxable estate. Some individuals transfer ownership to an irrevocable life insurance trust (ILIT) to avoid this. Once placed in an ILIT, the policyholder no longer has control, preventing the proceeds from being counted toward estate value—provided the transfer occurs at least three years before death, as required under IRC Section 2035.

Gifting a policy during one’s lifetime can also reduce estate tax exposure, but limitations apply. The IRS allows individuals to gift up to $18,000 per recipient annually in 2024 without triggering gift tax consequences. If the policy’s value exceeds this amount, the excess is applied toward the individual’s lifetime gift exemption, which is tied to the estate tax exemption. This strategy helps high-net-worth individuals minimize taxable assets while ensuring financial support for beneficiaries.

Cash Value Growth and Potential Liabilities

Permanent life insurance policies, such as whole life and universal life, accumulate cash value over time, growing tax-deferred. Whole life policies typically provide guaranteed returns, while universal life policies offer flexibility, with interest rates tied to prevailing market conditions. Indexed universal life policies link cash value growth to stock market indexes like the S&P 500, subject to caps and floors that limit both gains and losses.

If a policy lapses or is surrendered, tax consequences may arise. If the total cash value exceeds the cost basis—the amount of premiums paid—the excess is taxable income. For example, if a policyholder has paid $50,000 in premiums and the cash value has grown to $80,000, surrendering the policy results in $30,000 of taxable income, reported on a Form 1099-R. The tax rate depends on the individual’s income bracket, potentially increasing their overall tax burden for the year.

Policy fees and insurance costs can also impact cash value growth. Administrative charges, mortality expenses, and surrender fees can erode accumulated value, particularly in the early years of a policy. If these costs exceed the returns generated, cash value growth may stagnate or decline. This is especially relevant for variable universal life policies, where investment performance directly influences cash value. Poor market returns combined with high fees can lead to unexpected shortfalls, requiring additional premium payments to keep the policy in force.

Tax Implications of Loans or Withdrawals From Policies

Loans against a permanent life insurance policy are generally not taxable as long as the contract remains active. Since the borrowed amount is secured by the policy’s cash value, it is treated as a debt rather than income. Interest accrues on the loan at fixed or variable rates set by the insurer, and unpaid interest is added to the loan balance, reducing the net death benefit. If the loan grows too large relative to the remaining cash value, the policy may lapse, triggering tax liability on any amount exceeding the policyholder’s cost basis.

Withdrawals can create immediate tax consequences if they exceed the amount of premiums paid into the policy. Under the IRS’s “first-in, first-out” (FIFO) rule, withdrawals up to the total premiums paid are tax-free, but any amount beyond that is taxable income. For example, if a policyholder has contributed $40,000 in premiums and withdraws $50,000, the excess $10,000 is subject to ordinary income tax.

If the policy is classified as a modified endowment contract (MEC) due to excessive funding under IRS Section 7702A, withdrawals and loans are treated differently. Earnings are withdrawn first and taxed, with potential early withdrawal penalties applying before age 59½.