Is Life Insurance Money Taxable? What You Need to Know

⚠️ Important Tax Disclaimer

The information in this article is for general educational purposes only and is not tax, legal, or financial advice. Tax laws are complex and change frequently. Individual circumstances vary significantly. Before making any decisions regarding life insurance, cash value withdrawals, policy surrenders, or life settlements, you should consult with a qualified tax professional, certified public accountant (CPA), or licensed tax attorney who can evaluate your specific situation. This article does not create an advisor-client relationship and should not be relied upon as a substitute for professional tax advice.

Is life insurance money taxable? The answer is: it depends on which money you are talking about. Life insurance involves several different types of payments and values, and the IRS treats each one differently. Death benefits work one way. Cash value works another way. Surrender value has its own rules. And if you sell your policy through a life settlement or viatical settlement, that is a whole different tax situation.

If you are trying to figure out whether you will owe taxes on life insurance money, you need to understand which category applies to your situation. Let me break this down piece by piece so you know exactly what to expect.

Death Benefits Are Generally Tax Free

Let me start with the good news. If you are a beneficiary receiving life insurance proceeds because the insured person passed away, that money is generally not taxable. You do not have to report it as income on your tax return. The IRS does not consider life insurance death benefits to be taxable income to the beneficiary.

This is true whether you receive the money as a lump sum or in installments. The face value of the policy, the actual life insurance payouts, comes to you tax free in most situations.

However, there is one important exception. If the insurance company holds onto the money for a period of time before paying you, any interest that accumulates is taxable. The death benefit itself remains tax free, but the interest portion is considered taxable income and must be reported.

So if you receive a death benefit of $500,000 plus $5,000 in interest because the insurance company held the funds for several months, the $500,000 is tax free but the $5,000 in interest is taxable. You will receive a Form 1099 for the interest portion.

There is another exception worth mentioning. If the policy was transferred to you for cash or other valuable consideration before the insured died, different rules apply. In that case, the tax free exclusion is limited to the amount you paid plus any additional premiums. This is called the transfer for value rule, and it can create unexpected tax consequences if you are not careful.

Is Cash Value of Life Insurance Taxable?

Permanent life insurance policies like whole life insurance and universal life build up the policy's cash value over time. A portion of each premium payment goes into a cash value account that grows on a tax deferred basis. This is one of the selling points of permanent life insurance.

The cash value growth itself is not taxable while it sits inside your policy. You do not owe taxes each year on the gains accumulating in your cash value account. This tax deferred growth is similar to how retirement accounts work. The money grows without current taxation.

However, the tax treatment changes when you access that cash value. How you access it determines whether you owe taxes and how much.

Withdrawals from Cash Value

If you withdraw money from your life insurance cash value, the tax treatment depends on how much you withdraw relative to your basis. Your basis is essentially the total amount of premiums you have paid into the policy.

Withdrawals up to your basis are generally tax free. You are just getting back money you already paid in. But withdrawals that exceed your basis are taxable as ordinary income. You are now taking out gains that have never been taxed.

For example, say you have paid $50,000 in premiums over the years and your cash value has grown to $80,000. If you withdraw $40,000, that is less than your $50,000 basis, so it is tax free. But if you withdraw $60,000, the first $50,000 is tax free and the remaining $10,000 is taxable as ordinary income.

There is an important exception here. If your policy is classified as a modified endowment contract, or MEC, the rules flip. With a MEC, withdrawals come out gains first rather than basis first. That means you pay taxes on the gains before you get to your tax free basis. MECs are created when you fund a policy too aggressively relative to the death benefit. If you have a MEC, talk to a tax advisor before taking any withdrawals.

Policy Loans

One of the benefits of cash value life insurance is the ability to borrow against your policy. You can take out a loan using your cash value as collateral, and these loans are generally not considered taxable events.

The loan proceeds are not taxable income when you receive them. You are borrowing money, not withdrawing it. The policy remains in force and your cash value continues to grow.

However, there is a catch. If your policy lapses or you surrender it while you have an outstanding loan, the loan amount can become taxable. The IRS treats the unpaid loan balance as a distribution, and you could owe taxes on the amount that exceeds your basis.

This catches some people off guard. They take out a loan, stop paying premiums, the policy lapses, and suddenly they have a tax bill they were not expecting. If you have loans against your policy, make sure you understand the tax consequences before letting the policy lapse.

Is Life Insurance Surrender Value Taxable?

Here is where things get more significant. If you surrender your life insurance policy, meaning you cancel it and take the cash surrender value, you may owe taxes on the gain.

The cash surrender value is the amount the insurance company will pay you if you cancel your policy. It is typically lower than the total cash value because surrender charges and fees are deducted.

When you surrender a policy, the taxable amount is calculated as the difference between what you receive and what you paid in. If your cash surrender value exceeds your total premium payments, the excess is taxable as ordinary income.

For example, say you paid $100,000 in premiums over 20 years and your cash surrender value is $120,000. When you surrender the policy, you receive $120,000. Your basis is $100,000, so the $20,000 gain is taxable as ordinary income.

If your surrender value is less than what you paid in, you have a loss. Unfortunately, you generally cannot deduct this loss on your taxes because life insurance is considered a personal expense rather than an investment. You just absorb the loss.

The bottom line on surrender value: yes, the cash surrender value of life insurance can be taxable if it exceeds your basis. Plan accordingly. This is one reason some people explore the life insurance secondary market as an alternative to surrendering.

Taxation of Life Settlements

Now let us talk about what happens when you sell your life insurance policy to a third party through a life insurance buyout, also known as a life settlement. This is different from surrendering because you are selling to an outside investor rather than back to the insurance company.

The Tax Cuts and Jobs Act of 2017 clarified how life settlements are taxed, and the rules are actually more favorable than they used to be. Here is how it works.

Life settlement proceeds are taxed in three tiers:

• First tier: Proceeds up to your basis, meaning the total premiums you paid, are tax free. This is considered a return of your own money.
• Second tier: Proceeds above your basis but below the policy's cash surrender value are taxed as ordinary income. This represents the gains that would have been taxed as ordinary income if you had surrendered the policy.
• Third tier: Proceeds above the cash surrender value are taxed as capital gains. This is the premium you received for selling to a third party rather than surrendering to the insurance company.

Let me put some numbers to this. Say you paid $50,000 in premiums over the years. Your policy has a cash surrender value of $70,000. You sell the policy through a life settlement for $150,000.

The first $50,000 is tax free because that is your basis. The next $20,000, which is the amount from $50,000 to $70,000, is taxed as ordinary income. The remaining $80,000, which is the amount above the cash surrender value, is taxed as capital gains.

This three tier system means you get a mix of tax treatments, with the most favorable treatment, tax free and capital gains, applying to significant portions of the proceeds. It is generally more favorable than surrendering, where everything above basis is taxed as ordinary income.

One important note: the Tax Cuts and Jobs Act eliminated a previous rule that required you to reduce your basis by the cumulative cost of insurance charges. Under the old rules, this reduction created more taxable gains. The new rules put life settlement sellers on equal footing with people who surrender their policies. This is a taxpayer friendly change. You can learn more about how this factors into calculating your life settlement value.

Taxation of Viatical Settlements

Viatical settlements get their own special tax treatment, and it is very favorable. If you are terminally or chronically ill and sell your policy through a viatical settlement, the proceeds are generally completely tax free.

This tax exemption was established by HIPAA in 1996. Before HIPAA, viatical settlement proceeds were taxable just like any other income. The law changed to provide financial relief to people facing serious illness. The history of life settlements during the AIDS crisis played a significant role in shaping these rules.

To qualify for tax free treatment, you must meet specific requirements. For terminally ill individuals, a physician must certify that you have an illness or condition reasonably expected to result in death within 24 months. For chronically ill individuals, you must be certified as unable to perform at least two activities of daily living for a period of at least 90 days due to loss of functional capacity.

There is an additional requirement: the buyer must be a qualified viatical settlement provider. The IRS defines a qualified provider as one that regularly purchases policies from terminally and chronically ill individuals and is licensed in the state where the insured lives. If your state does not require licensing, the provider must comply with the disclosure and payment guidelines in the NAIC Viatical Settlements Model Act.

If you meet all the requirements, the entire viatical settlement is tax free. You do not have to pay federal income tax on any of the proceeds.

However, there are situations where viatical settlement proceeds could be taxable. If you are chronically ill, the tax free treatment only applies to proceeds used for long term care and medical expenses. If you use the money for other purposes, those proceeds could be taxable. If the purchaser is not a qualified provider, the settlement could be taxable even if you are terminally ill.

State tax treatment can also vary. Many states follow federal rules, but some may have different requirements. Check with a tax advisor familiar with your state's laws. You can also review our state-by-state guides for more information about regulations in your area.

Estate Tax Considerations

We have been talking about income tax, but there is another tax that can apply to life insurance: estate tax.

If you own a life insurance policy on your own life when you die, the death benefit is included in your estate for estate tax purposes. This is true even though the named beneficiary receives the money income tax free.

For most people, this is not a concern because the federal estate tax exemption is quite high, over $13 million per person in 2026. But if you have a large estate, life insurance owned by you could push your estate over the exemption threshold and trigger estate taxes.

There are strategies to avoid this, such as having someone else own the policy or using an irrevocable life insurance trust. But that is a topic for another day and another conversation with an estate planning attorney.

When to Consult a Tax Professional

Life insurance taxation can get complicated quickly, especially when you start combining different scenarios. If you are considering surrendering a policy, selling through a life settlement, or taking significant withdrawals or loans from cash value, I strongly recommend talking to a tax professional before you act.

A qualified tax advisor can review your specific situation, calculate your expected tax liability, and help you structure the transaction in the most tax efficient way possible. The cost of professional advice is usually well worth it compared to the potential tax savings or the cost of getting it wrong.

Understanding how life settlement underwriting works can also help you make more informed decisions about whether to pursue this option.

The Bottom Line

So is life insurance money taxable? Here is the quick summary:

• Death benefits paid to beneficiaries are generally tax free, though interest earned while the insurance company holds the funds is taxable.
• Cash value growth inside a policy is tax deferred. You do not owe taxes while it grows.
• Withdrawals from cash value are tax free up to your basis and taxable as ordinary income above your basis.
• Policy loans are not taxable when received, but can trigger taxes if the policy lapses with an outstanding loan balance.
• Surrendering a policy triggers ordinary income tax on any gain above your basis.
• Life settlement proceeds are taxed in three tiers: tax free up to basis, ordinary income up to cash surrender value, and capital gains above that.
• Viatical settlement proceeds are generally completely tax free if you meet the requirements for being terminally or chronically ill and use a qualified provider.

The tax treatment depends entirely on which category applies to your situation. When in doubt, talk to a tax professional before making any moves. If you are considering your options, you can get a free policy valuation to understand what your policy might be worth before consulting with your tax advisor.

Disclaimer: The information provided in this article is for general informational purposes only and does not constitute legal, financial, or professional advice. Life settlement regulations vary by state, and this content should not be relied upon as a substitute for consultation with a licensed professional. Please consult with a qualified attorney, financial advisor, or licensed life settlement broker before making any decisions regarding the sale of a life insurance policy.

Additional Notice: This article discusses general tax principles related to life insurance. It does not constitute tax advice and should not be relied upon for tax planning purposes. Tax laws are subject to change, and the application of tax rules depends on your individual circumstances. Always consult with a qualified tax professional, such as a CPA or tax attorney, before making decisions that may have tax implications. Neither the author nor this website assumes any responsibility for tax consequences arising from actions taken based on this article.