When Does Life Insurance Money Get Taxed?

Life insurance provides a monetary benefit to designated individuals or entities upon the insured’s death. A common misconception is that all proceeds are taxable. However, the tax treatment of life insurance money varies significantly based on how the funds are accessed and the specific circumstances surrounding the policy.

Taxation of Death Benefit Proceeds

Life insurance death benefits are generally received income tax-free by beneficiaries. This exclusion from gross income is a fundamental aspect of life insurance, codified under Internal Revenue Code Section 101. This tax-free status applies whether the beneficiary is an individual, a corporation, or a partnership.

However, specific situations exist where the death benefit may become partially or fully taxable. One exception is the “transfer for value” rule. This rule applies if a life insurance policy, or an interest in it, is sold or transferred for valuable consideration. The amount of the death benefit exceeding the consideration paid for the policy and any subsequent premiums paid by the transferee may become taxable as ordinary income. For instance, if a policy is transferred for a price, the new owner might be subject to income tax on the gain.

Exceptions to the transfer for value rule allow the death benefit to remain income tax-free even after a transfer. 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. Avoiding this rule is important, as it can change the tax-free nature of the death benefit.

Interest paid on retained proceeds can also be taxable. If a beneficiary chooses to leave the death benefit with the insurer, the interest earned on those funds is subject to income tax. While the principal death benefit remains tax-free, any growth generated by leaving the money with the insurance company will be taxable.

Taxation of Cash Value Access

Permanent life insurance policies, such as whole life or universal life, accumulate cash value that policyholders can access during their lifetime. The tax implications of accessing this cash value depend on the method. Cash value generally grows on a tax-deferred basis, meaning taxes are not owed on the growth until withdrawal.

Withdrawals from a policy’s cash value are treated on a “first-in, first-out” (FIFO) basis. This means withdrawals are considered to come from the premiums paid into the policy first, which are not taxable as they represent a return of your own money. Once the amount withdrawn exceeds the total premiums paid (your “basis”), any additional withdrawals are taxable income. This gain is taxed as ordinary income, not capital gains.

Policy loans offer another way to access cash value and are generally not taxable income as long as the policy remains in force. Loans are viewed as advances against the policy’s cash value, not a distribution of gains. However, if the policy lapses or is surrendered with an outstanding loan, the loan amount exceeding the policy’s basis can become taxable. This “loan gain” is treated as ordinary income.

Surrendering a life insurance policy means terminating coverage and receiving the accumulated cash value. When surrendered, any amount received exceeding the policyholder’s basis (premiums paid minus withdrawals) is taxable income. This excess is taxed at ordinary income rates.

Dividends paid by participating life insurance policies are generally not taxable, as they are considered a return of premiums. However, if dividends received exceed the total premiums paid into the policy, the excess may be taxable. If dividends are left with the insurer to earn interest, the interest earned is taxable income.

Policies classified as Modified Endowment Contracts (MECs) have different tax rules. A policy becomes an MEC if premiums paid exceed certain IRS limits, failing the “seven-pay test.” Once designated an MEC, its tax treatment for distributions changes. Withdrawals and loans from an MEC are taxed on a “last-in, first-out” (LIFO) basis, meaning earnings are taxed first, before any return of premium. These distributions are subject to ordinary income tax, and if the policyholder is under age 59½, an additional 10% penalty tax may apply to the taxable portion.

Estate and Gift Tax Implications

Life insurance proceeds can also have estate and gift tax implications, separate from income taxes. Life insurance death benefits are generally included in the deceased’s taxable estate if the deceased owned the policy or retained “incidents of ownership” at the time of death. Incidents of ownership include rights such as changing beneficiaries, surrendering or canceling the policy, assigning it, or borrowing against its cash value. If these rights were held by the insured, the full death benefit will be included in their estate for federal estate tax purposes.

To avoid inclusion of life insurance proceeds in the taxable estate, policy ownership can be transferred to another person or entity, such as an Irrevocable Life Insurance Trust (ILIT). An ILIT is an irrevocable trust designed to own life insurance policies, removing the death benefit from the insured’s taxable estate. When an ILIT owns the policy, the proceeds are not included in the grantor’s taxable estate, helping reduce potential estate tax liability. However, if an existing policy is transferred to an ILIT, the insured must survive at least three years from the transfer date for the proceeds to be excluded from the estate.

Transferring ownership of a life insurance policy during one’s lifetime can also trigger gift tax implications. If the policy’s value transferred exceeds the annual gift tax exclusion amount, it may be considered a taxable gift. For 2025, the annual gift tax exclusion is $19,000 per recipient. If the fair market value of the policy at the time of the gift exceeds this amount, the excess could be subject to gift tax. However, a large unified credit exists for estate and gift taxes, meaning most estates are not subject to these taxes. This credit allows individuals to transfer substantial wealth during life or at death without incurring federal estate or gift tax.