Is Life Insurance Taxable – Discover the Top Tax Benefits of Cash Value Life Insurance

Written by: Steven Gibbs | Last Updated on: May 29, 2024
Fact Checked by Jason Herring and Barry Brooksby (licensed insurance experts)

Insurance and Estates, a strategic life insurance provider composed of life insurance professionals, is committed to integrity in our editorial standards and transparency in how we receive compensation from our insurance partners.

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Many people think about life insurance as strictly a death benefit. A few more savvy individuals know that this death benefit is NOT taxable to the beneficiaries.

However, only the truly astute understand the tax advantages that permanent life insurance offers (as opposed to term life) not only to beneficiaries but to policy owners, providing living benefits to be used in life. After all, it is called “life” insurance for a reason.

As a teaser, permanent life insurance tax advantages may be used to expedite cash value accumulation for many purposes including retirement planning and investing. Further, Infinite banking strategies rely on the tax advantages of permanent life insurance .

This article will walk through the various tax benefits of permanent life insurance and, in the process, may even convince you to look at permanent life insurance as part of your financial plan for wealth building today and into the future.

Are Life Insurance Proceeds Taxable?

This most obvious tax benefit of life insurance is the fact that the beneficiaries of a life insurance death benefit do not pay income tax on the proceeds.

This is the only tax benefit that is offered by ALL types of life insurance policies INCLUDING term life and the various types of permanent life insurance. The amount of death benefit received by your beneficiary does not constitute taxable income.

26 U.S. Code Sec. 101, subsections (a) and (g), of the I.R.S. Tax Code provides that “proceeds from a life insurance policy payable by reason of death” are generally NOT included in the GROSS INCOME of the payee. EVEN in circumstances where “accelerated benefits” are paid to the policy holder, perhaps because they are terminally ill, this code section applies so that taxable income is not recognized.

Cash Value Life Insurance vs MEC

The following income tax advantages apply to all permanent life insurance contracts that accrue cash value. To accrue cash value, a policy must be a permanent (or cash value) life insurance policy as differentiated to a term (or temporary) life insurance policy.

For a permanent life insurance policy to qualify for tax advantages under the I.R.S. Code, the policy must be a life insurance contract NOT be a modified endowment contract (“MEC”).

26 U.S. Code Sec 7702 contains the rules that define an “insurance contract” as opposed to a MEC.

So, if a policy qualifies as an insurance contract, the pre-ordained tax advantages sanctioned by the I.R.S. code apply which include the following common benefits:

  1. Tax deferred growth
  2. Tax free dividends
  3. Cash withdrawals
  4. Policy loans

Is Life Insurance Tax Deductible?

Often insurance professionals respond to the question whether life insurance premiums are tax deductible with a resounding “no” and “sorry”.

IRC 264 (a) states that as a general rule no deduction shall be allowed for — (1) Premiums on any life insurance policy, or endowment or annuity contract, if the taxpayer is directly or indirectly a beneficiary under the policy or contract.(1)

However, the more complete answer to this question is that premiums may only be deducted as expenses in certain limited circumstances involving business expenses.

The key is if a business owner pays premiums on behalf of a key employee as part of an executive bonus plan, deferred compensation plan or split dollar plan, the premiums may be deductible if they are recognized as income to the employee.

The question of whether premiums are recognized as income for any of the above strategies is very fact specific, involving questions such as when the employee has access to the cash value in an insurance policy.

Permanent Life Insurance and Tax Deferred Growth

One of the advantages of life insurance that builds cash value is that cash value increase (or “gain”) is not realized (for tax purposes) until the gain is withdrawn from the policy.

The only way a cash withdrawal from your life insurance is taxed is if the amount withdrawn exceeds your basis, i.e. how much premiums you have paid into your policy.

This is true as long as the policy qualifies as an insurance contract EVEN IF strategies are used to maximize the policy cash value through paid up additions.

This an important advantage when considering permanent life insurance strategies such as the infinite banking concept®, which is based upon a number of concepts such as the velocity of money and creating financial arbitrage to facilitate other activities such as real estate wealth building strategies.

There are various types of permanent life insurance that all offer tax deferred cash value accumulation, which are indexed universal life insurance, variable life insurance, private placement life insurance, and dividend paying whole life insurance. And in some cases guaranteed universal life insurance offers some cash accumulation.

Tax Free Dividends 

For certain types of permanent life insurance policies, namely participating life insurance policies that pay dividends, the additional tax benefit of “tax free dividends” is available.

This is because the I.R.S. considers life insurance dividends to be a “return of premiums paid” rather than income.

This advantage is typically realized in policies issued by mutual whole life insurance companies.

But note, dividends paid that exceed the amount of premiums paid into the policy may likely be considered income by the I.R.S. when withdrawn from the policy.

Tax Free Policy Loans

The cash value in an insurance policy may be used as collateral to secure a loan from the insurance company up to the amount of the cash value in most cases.

This is another huge aspect of the infinite banking because you can access life insurance policy cash for retirement or other investments and your cash value in the policy keeps growing via compound interest.

With mutual life insurance companies, the payment of dividends applies to your entire cash value, even if you have an outstanding policy loan.

Tax Free Cash Withdrawals 

Even if cash is withdrawn from the policy’s cash value (verses taking it as a policy loan), this cash withdrawal is NOT considered income, or gain, until the amount exceeds the amount of premiums that have been paid into the policy.

However, it is important to know that if a policy is “surrendered” meaning that it is cashed out and terminated, surrender charges may apply even if no taxable income is recognized.

Estate Tax Advantages of Permanent Life Insurance

Life insurance is often used to provide liquidity to pay federal estate taxes. Term life insurance or permanent life may both be used for this purpose because the focus is the death benefit payable to the heirs.

However, for long term planning, a guaranteed universal life policy should be considered as minimum protection due to the rising cost of term insurance over a lifetime.

Liquidity and Business Continuity Succession Planning 

The issue of liquidity is especially critical for “asset heavy” businesses such as car dealerships, sports teams, or trucking companies. What often occurs is that the cash simply isn’t available to pay the estate taxes AND assets must therefore be sold or heavily leveraged.

Be aware that this issue can be compounded by the fact that lenders may be highly apprehensive to loan to a business during a time as unstable as following the death of a principal business owner.

This is a key consideration when undergoing family business succession planning as part of a business continuity succession plan.

Exceeding the Estate Tax Exemption

The keyto estate planning is remembering that estate taxes will be due if you exceed the federal estate tax exemption.

Any amount in excess of the exemption amount will be taxed at an approximate 40% rate, and this amount is typically due within 9 month of the estate owner’s date of death.

The taxable estate is determined based upon the gross value of the estate which includes all the estate assets as well as insurance death benefit payments.

Tip:  State inheritance taxes may also be due, independent of the federal estate tax burden. Thus it is important to understand the laws of your state of residence OR state of incorporation in order to avoid unpleasant estate tax surprises.

Using an ILIT for Estate Tax Planning

The strategy behind using an irrevocable life insurance trust (“ILIT”) for estate planning is moving assets out of the taxable estate.

This is because only assets that are owned by the deceased estate owner are deemed part of the estate tax calculation at time of death. Assets that were transferred outside of the estate simply “don’t count”.

So, when you transfer assets to an ILIT, either in a lump sum or over a period of years, those assets are moving from your estate into the trust that will then pass to your designated beneficiaries.

Transfers to ILITs are often done through gifting assets as part of a strategy to decrease an estate while providing a reserve for future generations.

Tip:  The I.R.S. imposes a 3 year rule which requires that assets must be in the ILIT for a minimum of 3 years prior to the estate owner’s date of death in order to be excluded from the taxable estate.


Life insurance is a tax advantaged savings vehicle that provides liquidity, control and leverage. It makes an excellent tool for estate planning but the living benefits are the real hidden secret to this fantastic wealth building tool.

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