Alyssa Lane
Life insurance provides peace of mind and a financial safety net for your loved ones in the event of your death. But what happens when it comes to cashing in on a policy? The short answer is: it depends. In most cases, life insurance death benefits are not taxed as income. However, there are certain situations where life insurance can be taxable, including withdrawing or borrowing cash value, or surrendering a permanent policy. The type of policy, the size of your estate, and how benefits are paid out will dictate whether your life insurance benefits will be taxed.
| Characteristics | Values |
|---|---|
| Life insurance proceeds received as a beneficiary due to the death of the insured person | Not taxable |
| Interest received on life insurance proceeds | Taxable |
| Transfer of policy for cash or other valuable consideration | Taxable |
| Life insurance proceeds received by the policyholder with a terminal illness diagnosis | Taxable |
| Surrender or cancellation of the policy by the policyholder | Taxable if the amount received is more than the cost of the policy |
| Borrowing against the cash value of a policy | Not taxable unless the policy lapses or is surrendered without repayment of the loan |
| Withdrawals, loans, and assignments of a Modified Endowment Contract (MEC) | Income taxable to the extent of the gain in the policy |
| Policy distributions (dividends, withdrawals, or partial surrenders) | First treated as a return of the cost basis; only distributions that exceed the policy's cost basis are taxable |
| Interest credited to a dividend accumulation account | Taxable to the policyowner |
| Distributions made during the first 15 policy years resulting in a substantial reduction in death benefits | Portion of the cash distributed ("recapture" amount) may be treated as distribution of policy earnings and subject to tax |
| Policy loans eliminated during a 1035 exchange | Taxable to the extent of any gain in the policy at the time of the exchange |
| Death benefit left to the estate instead of directly naming a person as the beneficiary | May be subject to estate tax |
| Death benefit received by the new owner of the policy | Taxable if it exceeds what they paid for the policy, plus any premiums they've continued to pay |
What You'll Learn
Borrowing from your policy's cash value is tax-free, but loans are not
Borrowing from the cash value of your life insurance policy is a popular feature of permanent life insurance. This is because the policyowner can borrow against the policy without incurring any immediate tax consequences. However, it is important to note that this is not a tax-free loan. If you surrender your policy or your policy lapses, you must pay taxes on the money that came from interest or investment gains, even if you have an outstanding loan. This is because the gain on a life insurance policy is taxable, even if all the cash value is used to repay an existing policy loan.
The cash value of a life insurance policy is not usually taxable, but there are some cases where you will have to pay taxes. For example, if you take out a loan from your life insurance plan and the policy terminates before you have repaid the loan, you may be taxed on the total amount. Additionally, if you withdraw any gains, such as dividends, they are typically taxed as ordinary income.
It is worth noting that the type of policy you have, the size of your estate, and the way the benefit is paid out will all dictate whether your life insurance benefits will be taxed. For example, if you opt for monthly installments instead of a lump sum, the funds that have yet to be distributed will accrue taxable interest. Therefore, it is important to understand how taxation applies to your unique tax situation before moving forward with a policy.
While borrowing against your life insurance policy can provide urgently needed money, it is important to exercise caution. If you handle the loan poorly, you may sabotage the reasons for having the policy in the first place, lose the policy, or create an income tax bill that you cannot afford to pay. There is no repayment schedule for these loans, and you may never have to repay the loan at all. However, if the loan is not repaid before the insured person's death, the insurance company will reduce the face amount of the insurance policy by what is still owed.
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Surrendering a policy is taxable, but selling it is not
Surrendering a life insurance policy may trigger tax consequences, which the IRS refers to as a taxable event. This primarily depends on whether the surrender value is more than the premiums you've paid. Surrender charges can also reduce the amount you get from cashing out your policy and the amount of taxable gain you might pay.
However, selling your life insurance policy to a third party is not taxable. The difference between the amount you receive from the sale and your tax basis in the policy will be subject to tax. The gain you realize on the policy sale could be ordinary income, capital gain, or both, depending on the cash surrender value of the policy. For example, if you sell a policy with a face value of $100,000, a cash surrender value of $40,000, and premium payments of $30,000 for $75,000, you will report income of $45,000. Of that $45,000, the difference between the policy cash surrender value of $40,000 and the policy basis of $30,000, or $10,000, must be reported as ordinary income.
Term life insurance does not carry any cash value, meaning there is no surrender value to the contract, and therefore no tax consequences for surrendering it. Cash value policies, on the other hand, are more complex. Surrendering a cash value policy may provide you with the accumulated cash value, which can be taxable minus any surrender charges. However, to trigger tax charges, the cash value must be more than the amount of money you paid in premiums for the policy.
If you take out a loan from your life insurance plan, it won't be taxable unless the policy terminates before you've repaid the loan. You can withdraw up to the total amount of the premiums you've paid without paying taxes, but withdrawing gains such as dividends will be taxed as ordinary income.
In general, a life insurance benefit isn't subject to taxes, but there are exceptions. The type of policy, the size of your estate, and the way the benefit is paid out will dictate if your life insurance benefits will be taxed. For example, if you opt for monthly installments rather than a lump sum, the funds that have yet to be distributed will accrue taxable interest.
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Interest accrued on instalments is taxable income
In most cases, life insurance death benefits are not taxed as income. However, there are certain situations where life insurance can be taxable. For example, if you withdraw or borrow cash value, or surrender a permanent policy, you may be taxed. If you opt for monthly instalments instead of a lump sum, the funds that have yet to be distributed will accrue taxable interest.
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Naming your estate as beneficiary may incur taxes
Naming your estate as the beneficiary of your life insurance policy may come with tax implications. While the cash value of life insurance is not usually taxable, there are some cases where you or your beneficiaries will have to pay taxes on it.
If you take out a loan from your life insurance plan, it won't be taxable as long as the policy remains active. However, if the policy terminates before you've repaid the loan, you may be taxed on the outstanding amount. You can withdraw up to the total amount of the premiums you've paid without paying taxes, but withdrawing any gains, such as dividends, will be taxed as ordinary income. If you opt for monthly installments instead of a lump sum, the funds that have yet to be distributed will accrue taxable interest.
If you surrender a whole life policy, the insurance company will cash out the policy's cash value minus any fees, taxes, or other charges. If there isn't enough cash value to cover these expenses, you may be responsible for paying them yourself. Additionally, if you've taken out loans against your policy, these must be repaid, and you may be subject to surrender charges or other penalties if you're below a certain age, usually around 65.
In the case of a second-to-die policy, the policyowner can exchange the existing policy for a new one on the life of the surviving insured after the death of the first insured. If a loan is paid off as part of this exchange, the lesser of the gain in the policy or the amount of the loan repaid is taxable to the policyowner.
It's important to understand the tax implications of your life insurance policy to make informed decisions and avoid unexpected costs. Consulting a financial advisor or tax professional can help you navigate the complexities of your specific situation.
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Modified Endowment Contracts (MECs) are taxed differently
A Modified Endowment Contract (MEC) is a cash value life insurance policy that has lost its tax benefits because it contains too much cash. The MEC limits for a policy will depend on its terms and death benefit amount. The IRS no longer recognises a policy as a life insurance contract when the total collected premiums and cash value exceed federal tax-law limits. This limit is set based on IRS rules about the maximum amount of premiums that can be paid into the policy in its first seven years.
The IRS uses the 7-pay test to determine whether a policy has become an MEC. If, at any point during those first seven years, you've paid more than what's required to fully fund the policy, you fail the test and the policy becomes an MEC. MEC status is irreversible, making it crucial to manage premium payments to avoid it unless specifically desired.
MECs are taxed differently from life insurance policies. Withdrawals and loans from an MEC are taxed on a last-in-first-out (LIFO) basis, potentially incurring penalties if done before the age of 59 and a half. Unlike a standard life insurance contract, money withdrawn from an MEC comes first from your earnings and then from your principal.
However, MECs do offer some benefits. MEC death benefits aren't subject to taxation, and policy owners who don't make withdrawals can pass on a significant sum of money to their beneficiaries without probate proceedings. MECs also often offer a better low-risk yield than savings accounts and can be useful for individuals interested in tax-sheltered, investment-rich policies.
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Frequently asked questions
Yes, the cash value of life insurance grows tax-free. This means that, in many cases, you won’t have to worry about paying taxes on it.
If you take out a loan from your life insurance plan, the loan won’t be taxable as long as the policy remains active. If the policy terminates before you’ve repaid the loan, you might get hit with a tax bill. You can withdraw up to the amount of the total premiums you’ve paid into the policy without paying taxes, but any amount above the cash value is subject to capital tax gains.
Yes, the proceeds above what you paid in will be taxable. For example, if you paid $10,000 into your life insurance policy and sold it for $25,000, the extra $15,000 would be taxable.
Surrendering a policy is typically done to the insurance provider. The cash surrender value amount is predetermined by the insurer and is usually similar to or less than the amount of money you paid into the policy. Little or none of the surrender value of a policy is taxed because you receive a similar amount or less money than you paid in.
Yes, you can borrow or withdraw from the policy’s cash value or sell your policy through a viatical settlement. This money will be tax-free as long as it is used for premiums or other specified expenses.
