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Is Life Insurance Taxable? Compare Policies With 8 Leading Insurers. One of the primary upsides to life insurance is that the payout is made to your beneficiaries tax-free. Since life insurance death benefits can be in the millions of dollars, it’s a significant advantage to buying (and receiving) life insurance.

But there are other aspects to life insurance that won’t get past the tax man. Here’s a look at when to prepare for a tax bill.

You Withdraw Money from Cash Value

If you have a cash value life insurance policy, you can generally access the money through a withdrawal or loan, or by surrendering the policy and ending it.

One of the reasons to buy cash value life insurance is to have access to the money that builds up within the policy. When you pay premiums, the payments generally go to three places: cash value, the cost to insure you, and policy fees and charges. Money within the cash value account grows tax-free, based on the interest or investment gains it earns (depending on the policy). But once you withdraw the money, you could face a tax bill.

Money that’s withdrawn is generally made up of two parts:

  • Money that came from premium payments you made. This component of a withdrawal is not taxable. In the life insurance industry this part is called the “policy basis.”
  • Money that came from interest or investment gains. This portion is subject to income taxes. Your life insurance company will be able to tell you what amount in a withdrawal is “above basis” and taxable.

If your life insurance policy is a “modified endowment contract,” or MEC, different tax rules apply and it’s best to consult a financial professional to understand tax implications.

You Surrender the Policy

There can be times when a policy owner no longer wants or needs the life insurance policy. You can take the surrender value of the policy, and the insurer will terminate the coverage. The amount you receive is your cash value minus any surrender charge. You can generally expect to get a surrender charge within the first 10 or 20 years of owning the policy, and over the course of time the surrender charge phases out.

You won’t be taxed on the entire surrender value, though. You’ll be taxed on the amount you received minus the policy basis. This taxable amount reflects the investment gains that you took out.

You Took Out a Policy Loan and the Life Insurance Ends

If you have a policy with cash value and take out a loan against it, the loan isn’t taxable –as long as the policy is in-force. But if the policy terminates before you’ve paid the loan back, you could get a tax bill. For example, if you surrender the policy or it lapses, the coverage terminates.

The taxable amount is based on the amount of the loan that exceeds your policy basis. Remember, policy basis is the portion you’ve paid in as premiums. Amounts “above basis” are based on interest or investment gains on cash value.

One way to access all your cash value and avoid taxes is to withdraw the amount that’s your policy basis — this is not taxable. Then access the rest of the cash value with a loan — also not taxable.

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You Sell the Life Insurance Policy

There’s a market for existing life insurance policies, especially cash value life insurance policies that insure people who are terminally ill or have short life expectancies. Transactions involving terminally ill policy owners are called “viatical settlements.” These involve an investor, such as a company specializing in buying policies, paying you money for the policy, becoming the policy owner, and then making the life insurance claim when you pass away.

Viatical settlements are typically used as a way for patients to get money for medical bills, especially when selling a life insurance policy will mean getting more money than simply surrendering it for the cash value.

Fortunately, the IRS doesn’t treat any portion of what you receive for a viatical settlement as taxable. Under IRS code 101(g)(2), an amount paid by a viatical settlement provider is treated like a payment of the death benefit — and death benefit payouts are not taxable.

life settlement is a similar transaction but involves a policy owner who is not terminally ill. In these cases the IRS does not see the proceeds as a payment of death benefit. A portion of what you receive can be taxable.

You Are Life Insurance Beneficiary Who Receives Interest on a Death Benefit

Most life insurance payouts are made in one lump sum right after the death of the insured person. But some beneficiaries choose to delay the payout, or choose to take the payout in installments over time. When these delayed payouts include interest from the life insurer, the interest can be taxable.

The Life Insurance Payout Goes Into a Taxable Estate

Most life insurance payouts are made tax-free directly to life insurance beneficiaries. But if a beneficiary was not named, or is already deceased, where does the life insurance death benefit go? It goes into the estate of the insured person and can be taxable along with the rest of the estate.

This could create a significant tax bill, especially considering both federal and state estate taxes. While federal estates taxes will not tax the first $11.7 million per individual (in 2021), state estate taxes can have significantly lower exemption levels.

Another possible unhappy scenario is that an estate is below the exemption level but a large life insurance payout into the estate pushes it above the exemption threshold into taxable territory.

This should all be avoidable by naming both primary and contingent life insurance beneficiaries, and keeping those selections up to date.

Summary: When Is Life Insurance Taxable?

Situation What part could be taxable?
You withdraw money from cash value Any amount you receive above “policy basis”
You surrender a policy for cash Any amount you receive above “policy basis”
You take a loan against the cash value None, as long as the policy remains in-force
You sell the policy through a viatical settlement None
You’re a beneficiary who receives a life insurance payout plus interest The interest amount
The life insurance payout goes into your estate Any amount of the estate that’s subject to state or federal estate taxes.
You sell your life insurance in a viatical settlement None

Read more related articles at:

How to avoid the federal estate tax when collecting life insurance proceeds

Taxes on life insurance: Here’s when proceeds are taxable

Also, Read one of our previous blogs at:

How Can Life Insurance Help My Estate Plan?

Click here to check out our On Demand Video about Estate Planning.