When and How Can Life Insurance Be Taxed?

Life insurance often serves as a foundational component of financial planning, providing a financial safety net for loved ones. While various tax advantages exist, certain scenarios can trigger tax liabilities. Understanding these circumstances is essential for effective financial management.

Tax Treatment of Life Insurance Death Benefits

Generally, death benefits paid to beneficiaries from a life insurance policy are not subject to income tax. The lump sum payment received by the designated individual or entity typically arrives free of federal income tax. This tax-free treatment applies regardless of the type of life insurance, whether it is term, whole, or universal life coverage. These tax-free proceeds help beneficiaries address immediate financial needs, such as covering funeral costs, paying off debts, or replacing lost income.

Despite the general rule, there are specific situations where life insurance death benefits can become taxable. One such exception is the “transferred for value” rule. If a life insurance policy is sold or transferred for valuable consideration, the death benefit may become partially or fully taxable to the recipient. The taxable amount is generally the death benefit minus the consideration paid for the policy and any subsequent premiums paid by the new owner.

Another instance where tax can apply is when death benefits are paid out in installments rather than a single lump sum. While the principal amount of the death benefit remains income tax-free, any interest that accumulates on the deferred payments is considered taxable income to the beneficiary.

Employer-owned life insurance (EOLI) can also have tax implications for the death benefit. Under Internal Revenue Code Section 101(j), proceeds from certain EOLI contracts issued after August 17, 2006, may be included in the gross income of the beneficiary, typically the employer.

Tax Treatment of Life Insurance Cash Value and Distributions

Permanent life insurance policies, such as whole life or universal life, include a cash value component that grows over time. This growth occurs on a tax-deferred basis; policyholders do not pay taxes on accumulated gains as long as the cash value remains within the policy. This tax deferral allows the cash value to compound efficiently.

Accessing the cash value through withdrawals can lead to tax consequences depending on the amount withdrawn. Withdrawals are considered a return of premiums paid (cost basis) and are tax-free up to this amount. If withdrawals exceed the total premiums paid into the policy, the excess amount is considered taxable income. This gain is taxed at ordinary income rates, not capital gains rates.

Policy loans against the cash value are generally not treated as taxable income, as they are considered a debt against the policy, not a distribution of gains. Policyholders are not required to repay these loans on a fixed schedule, though interest accrues. If a policy lapses or is surrendered with an outstanding loan balance that exceeds the policy’s cost basis, the amount of the loan exceeding the cost basis can become taxable as ordinary income.

Surrendering a permanent life insurance policy for its cash value can also trigger a tax liability. If the cash surrender value received is greater than the total premiums paid into the policy (the cost basis), the difference represents a gain that is taxable as ordinary income. Conversely, if the cash surrender value is less than or equal to the premiums paid, no taxable gain occurs.

A policy can be classified as a Modified Endowment Contract (MEC) if it fails the “seven-pay test,” meaning that premiums paid during the first seven years exceed specific IRS limits. Once a policy becomes a MEC, its tax treatment for distributions changes permanently. Withdrawals and loans from a MEC are taxed on a “last-in, first-out” (LIFO) basis, meaning gains are considered distributed first and are taxable as ordinary income. Distributions from a MEC taken before the policyholder reaches age 59½ may be subject to an additional 10% federal penalty tax on the taxable portion.

Life Insurance and Estate Taxes

Life insurance proceeds can be subject to federal estate tax under specific circumstances, even though they are generally income tax-free to the beneficiary. If the insured individual retains “incidents of ownership” over the policy at the time of death, the death benefit proceeds are included in their taxable estate. Incidents of ownership refer to any rights the insured has to control the policy, such as the ability to change the beneficiary, borrow against the cash value, or surrender the policy.

To remove life insurance proceeds from a taxable estate, an Irrevocable Life Insurance Trust (ILIT) can be established. An ILIT is an irrevocable trust designed to own the life insurance policy, thereby removing the incidents of ownership from the insured. The death benefit is paid directly to the trust and is excluded from the insured’s gross estate for estate tax purposes, providing liquidity to the estate without increasing its taxable value.

The federal estate tax exemption amount determines estate tax applicability. For 2025, the federal estate tax exemption is $13.99 million per individual. For married couples, the combined exemption is $27.98 million. Only the portion of the estate exceeding this threshold is taxed.

A three-year rule applies to gifts of life insurance policies. If an existing life insurance policy is transferred to an ILIT, or another individual, and the insured dies within three years of the transfer, the death benefit proceeds will be included in the insured’s taxable estate.

Other Tax Considerations for Life Insurance

Gifting a life insurance policy or paying premiums for a policy owned by another person can have gift tax implications. Such gifts fall under the annual gift tax exclusion, allowing individuals to give a certain amount to any number of recipients each year without incurring gift tax or using their lifetime gift tax exemption. For 2025, this annual exclusion is $19,000 per recipient. If a gift exceeds this amount, the excess reduces the donor’s lifetime gift tax exemption, which is unified with the estate tax exemption.

A 1035 exchange allows for the tax-free transfer of funds from one life insurance policy to another, or to an annuity contract. This provision enables policyholders to switch policies without triggering immediate taxation on accumulated gains. The exchange must be a “like-kind” transfer, such as life insurance for life insurance, and the ownership of the policies must remain the same for the tax-free treatment to apply.

Accelerated death benefits, also known as living benefits, are payments received from a life insurance policy while the insured is still alive, typically due to a terminal or chronic illness. These tax-free benefits help individuals cover medical expenses or other costs during severe illness.