Life Insurance Taxation – The Definitive Guide

February 28, 2023
Written by: Steven Gibbs | Last Updated on: April 23, 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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The number one danger to building wealth and creating a legacy is death and taxes. The good news is that permanent life insurance provides protection against both. In the following article, we do a deep dive into life insurance taxation to help you make a more informed decision about how you can best secure your financial future.

For more reading on the subject of taxes and life insurance, please see our articles Is Life Insurance Taxable? and IRC Section 7702 Explained.

Where Taxes May Impact Life Insurance Funds

When the insured person on a life insurance policy dies, a lump sum death benefit is typically paid out to the beneficiary(ies) who are named in the policy. These funds are generally received income tax free. But this doesn’t mean that money that comes out of a life insurance policy will never be subject to taxation.

The most common methods for receiving funds from a life insurance policy include:

  • Death benefit proceeds
  • Cash value withdrawals
  • Policy loans
  • Living Benefits / Accelerated Death Benefits

Taking a closer look at each of these can help you to see where you (or other recipients) could run into tax issues, as well as strategies for positioning a policy to help reduce or eliminate taxes that may be due.

Life Insurance Death Benefits

One of the primary advantages related to life insurance is that the death benefit proceeds are typically received by the beneficiary (or beneficiaries) free of income taxation. That way, the recipient(s) are able to use 100% of the insurance protection for various needs.

So, when could life insurance death benefits be taxable?

There are actually several possible scenarios. First, most life insurance carriers offer beneficiaries different methods of receiving death benefit proceeds. For instance, in lieu of a single lump sum payout, a beneficiary may instead opt to take their funds as:

  • Installment payments
  • An annuity
  • A retained asset account

With installment payments and the annuity option, the death benefit proceeds and accumulated interest are paid out on a regular basis, either for a set period of time – usually anywhere between five and forty years – or even for the remainder of the recipient’s lifetime, no matter how long that may be.

If the recipient is in or near retirement, the guaranteed stream of lifetime income can help to alleviate one of the biggest fears on the minds of many people today – running out of money while it is still needed.

In the case of installment and annuity payments, any interest that is received by the recipient will be taxed as ordinary income, whereas the funds that are considered to be a return of the initial death benefit proceeds will be tax-free.

A different option for receiving proceeds from a life insurance policy is via a retained asset account. For example, some insurance companies offer beneficiaries a “checkbook,” rather than paying out a single lump sum of cash or installment payments.

Checks may then be written against the balance of the account. Although deposits may not be made into a retained asset account, the funds that are inside can generate interest.

So, funds that are accessed by the beneficiary that represent interest or gain will be taxable at the recipient’s ordinary income tax rate (and funds that represent receipt of the initial death benefit will not be taxable).

It is important to note that while the lump sum death benefit from a life insurance policy is received free of income taxation, it could be subject to estate tax if the funds are included as part of your taxable estate.

According to the IRS, the value of life insurance proceeds will be included in your gross estate if the proceeds are payable to:

  • Your estate – either directly or indirectly, or
  • A named beneficiary (or beneficiaries), if you possessed any incidence of ownership of the policy at the time of your passing

Each year, however, the IRS mandates an amount of estate tax exemption, below which a decedent’s estate may not be taxable.

Estate Tax Exemption Amounts Over Time in the U.S.

Period Amount of Exemption
1977 (Quarters 1 and 2) $30,000
1977 (Quarters 3 and 4) $120,667
1978 $134,000
1979 $147,333
1980 $161,563
1981 $175,625
1982 $225,000
1983 $275,000
1984 $325,000
1985 $400,000
1986 $500,000
1987 – 1997 $600,000
1998 $625,000
1999 $650,000
2000 – 2001 $675,000
2002 – 2010 $1,000,000
2011 $5,000,000
2012 $5,120,000
2013 $5,250,000
2014 $5,340,000
2015 $5,430,000
2016 $5,450,000
2017 $5,490,000
2018 $11,180,000
2019 $11,400,000
2020 $11,580,000
2021 $11,700,000
2022 $12,060,000

Source: Estate Tax Exemption Amount Goes Up for 2022. Kiplinger. November 10, 2021.

States With An Estate Tax

Depending on where you reside, it is possible that your estate – including the value of any life insurance proceeds that are included in it – may also be subject to state estate tax, too.

In addition to the District of Columbia, the following states impose estate and/or inheritance taxes:

  • Connecticut
  • Hawaii
  • Illinois
  • Maine
  • Maryland
  • Massachusetts
  • Minnesota
  • New York
  • Oregon
  • Rhode Island
  • Vermont
  • Washington

If you do have an estate that is valued at $12.06 million or more (in 2022), and you are not passing your assets along to a spouse (because you are single or your spouse has pre-deceased you), then your assets – and essentially, your loved ones – could face a federal estate tax of up to 40%.

Federal Estate Tax Rates

For Taxable Estates in this Range You’ll Pay This Base Amount of Tax Plus This Rate on the Excess Above the Lower End of the Range
$0 to $10,000 $0 18%
$10,001 to $20,000 $1,800 20%
$20,001 to $40,000 $3,800 22%
$40,001 to $60,000 $8,200 24%
$60,001 to $80,000 $13,000 26%
$80,001 to $100,000 $18,200 28%
$100,001 to $150,000 $23,800 30%
$150,001 to $250,000 $38,800 32%
$250,001 to $500,000 $70,800 34%
$500,001 to $750,000 $155,800 37%
$750,000 to $1 million $248,300 39%
Over $1 million $345,800 40%

Source: Internal Revenue Service

If your estate exceeds the amount of the exemption, though, there are strategies that could be put in place that can reduce, or possibly even eliminate estate taxes – and oftentimes these techniques involve life insurance.

So, while the death benefit proceeds and/or the cash value of a life insurance policy can be taxable, if the plan is properly set up, it could actually help you to reduce or eliminate taxes.

Cash Value Withdrawals

withdraw cash valueIn a permanent life insurance policy – which can include whole life, universal life, variable life, variable universal life, and indexed universal life coverage – the cash value is allowed to grow on a tax-deferred basis. This means that there is no tax due on the gain that takes place unless or until it is withdrawn.

The tax-advantaged nature of life insurance cash value can allow the opportunity for the funds to grow and compound exponentially compared to a fully taxable account – especially over a long period of time. This is because a return can be generated on the principal, as well as on the previous growth, and on the funds that otherwise would have been paid out in taxes.

For this reason, there are some individuals who purchase cash value life insurance not so much for the death benefit that it can provide, but because they have already “maxed out” the annual funding limit on tax-advantaged IRAs (Individual Retirement Accounts) and/or employer-sponsored retirement plans, and they want the opportunity to contribute and grow additional funds.

Growth in a Taxable versus Tax-Deferred Account

(with all other factors being equal)

In addition to paying taxes on the gains if you withdraw money from the cash value component, though, it is also possible that you could incur a surrender, or early withdrawal charge from the life insurance policy if you cancel the policy, or if you withdraw more than an annual maximum allowable amount of cash value – oftentimes 10% – in any given year during the surrender charge period.

The surrender charge is usually used by the life insurance carrier to cover the costs of the coverage when it was on the insurer’s books. The percentage of the charge will typically be reduced over time, until it eventually disappears.

In addition to possibly paying a surrender charge, if you make withdrawals from a life insurance policy’s cash value before you have turned age 59 ½, you could also incur an additional IRS early withdrawal penalty of 10%. This is in addition to any taxes and/or surrender charges that are due.

With that in mind, withdrawing funds from the cash value component should typically only be considered as a last resort – at least during the early years of the policy. Otherwise, you could end up netting out only about half of what you remove from the plan. Therefore, permanent life insurance should typically be considered as a longer-term financial commitment.

Life Insurance Policy Loans

Rather than taking out taxable withdrawals from the cash value component of a life insurance policy, there is an alternative for accessing funds tax free. This is through a tax-free life insurance policy loan.

In addition to accessing funds tax-free through a life insurance policy loan, there are some other enticing benefits that can also come along with using this strategy. For instance, you are not technically borrowing funds from the policy’s cash value, but rather using the money as collateral for a loan from the insurance carrier.

Because of that, interest on all of the cash value can still continue to accumulate tax-deferred. As an example, if the cash value of the policy is valued at $100,000 and you take out a $20,000 loan, the cash value will earn interest on $100,000.

In addition, even though interest will accrue on the unpaid balance of the policy loan, these funds do not necessarily have to be repaid – at least not during the insured’s lifetime. In this case, if the insured passes away while there is still an outstanding loan balance, it will be paid using the death benefit proceeds. Then, the remainder of the death benefit will be paid out to the beneficiary(ies).

Living Benefits / Accelerated Death Benefits on Life Insurance Policies

life insurance with living benefitsSome life insurance policies offer “living benefits.” These can allow you to withdraw funds from the policy’s death benefit while you are still alive and use them for various healthcare or long-term care expenses.

Life insurance living benefits are usually added through an accelerated death benefit rider. Depending on the policy, there may or may not be an additional premium charge for this. Some common living benefit riders include the:

  • Terminal illness rider. In order to qualify for this, the insured must have been diagnosed with a terminal illness and have a life expectancy of between 6 to 24 months, depending on the policy and the insurance carrier.
  • Chronic illness rider. If the insured is unable to perform certain daily living activities – such as dressing or bathing – on his or her own, then they may be able to access funds if the policy includes a chronic illness rider.
  • Critical illness rider. If the insured has a critical illness – such as kidney failure, stroke, or cancer – then they may qualify for living benefits through a critical illness rider.
  • Long-term care rider. If the insured requires qualifying long-term care services, then they may be allowed to access accelerated death benefits via a long-term care rider.

Typically, accelerated death benefits are not taxed as income to the recipient. In addition, policies will usually have limits imposed on how much of the death benefit may be accessed as living benefits, such as 50% or 75% of the total.

It is also important to note that accessing funds from the death benefit will reduce the amount of proceeds that are ultimately paid out to the beneficiary(ies) upon the insured’s passing. So, if receiving less will create a financial hardship for survivors, the living benefit option may not be a good financial move.

Leaving More for Loved Ones and Less for Uncle Sam

If your loved ones will owe estate taxes upon your passing, whether or not the value of a life insurance policy is included in the taxable estate is dependent on how the coverage is owned.

For instance, if you are the owner and the insured, then the amount of the proceeds will be considered a part of your overall estate, and as such, will be included when determining how much estate tax is owed.


irrevocable life insurance trustIn order to keep these funds from being included in your overall estate value, it will be necessary to transfer the ownership to another person or entity. One strategy that is oftentimes used is placing the policy’s ownership with an irrevocable life insurance trust, or ILIT.

With an irrevocable trust, the terms may not be modified, amended, or terminated without the permission of the beneficiary(ies). This is in contrast to a revocable trust, whereby the grantor may make changes – or even cancel the trust altogether – but the assets inside of the trust are still considered in his or her overall estate value for tax purposes.

A life insurance policy that is already in force may be placed into the irrevocable life insurance trust. Alternatively, the ILIT trust may purchase a new policy, with the ILIT as the owner of the coverage.

Upon the death of the insured, the proceeds from the life insurance policy are paid to the trust. (The trust document of the ILIT will generally include the provisions for how the funds from the policy are to be used).

For instance, some or all of the money could be used for paying any taxes that are due on the remainder of the insured’s estate. Similarly, the life insurance proceeds may also be used for replacing assets that are used for the payment of the estate taxes.

Some items to be mindful of when you change the ownership of a life insurance policy include:

  • The inability for you to make any changes to the policy in the future
  • The new owner must continue to pay the premiums on the policy
  • The competency / knowledge of the new owner regarding life insurance and other financial matters

Are Funds Received from a Life Insurance Policy Taxable?

They could be – depending on how they are accessed!

While people don’t typically enjoy discussing life insurance – because it can remind you of your mortality – the reality is that this flexible financial vehicle can be an integral part of most any complete retirement or estate plan. There are literally endless reasons why people may purchase life insurance coverage, such as debt payoff and income replacement for survivors when the insured passes away.

But what many don’t realize is that life insurance can also be beneficial in many ways while the insured is still alive. For instance, funds in certain types of policies could be used for supplementing retirement income, making high ticket purchases, or paying off higher-interest debts such as credit card balances.

In any case, though, it is important to understand the tax treatment of life insurance proceeds, as well as the cash value in permanent policies. Otherwise, you could end up handing over a sizeable portion of the funds to the IRS.

So, knowing what you intend to use the policy for, along with your other short- and long-term financial objectives, can help you to narrow down which type of life insurance – if any – is right for you.

How Life Insurance Funds Can Be Accessed

Depending on the policy, there are several different ways that funds from life insurance may be accessed. For instance, with term life insurance, there is only death benefit protection, with no cash or investment component.

These policies are purchased – and they typically will remain in force for a pre-set time period, or “term,” such as 10 years, 20 years, or even for 30 years – provided that the premium is paid. If the insured dies while the policy is in force, the death benefit proceeds are paid out to the named beneficiary(ies).

The other category of life insurance – permanent – has both a death benefit and a cash value (or investment) component. These policies will also pay out the death benefit proceeds upon the insured’s passing. But permanent life insurance can also serve a plethora of other financial needs, too.

Based on the type of permanent policy you have, the cash value can grow and compound, and its return is tied to either a rate of return that is set by the insurance company, or it is instead linked to the performance of underlying investments (such as mutual funds) or market indexes (like the S&P 500 or the Dow Jones Industrial Average).

It is important to note, though, that while life insurance benefits are typically free of income taxation, all funds that are received through a life insurance policy are not necessarily always tax free.

In fact, depending on how someone takes receipt of the funds, it is possible that they could be subject to estate taxes and/or ordinary income tax, as well as surrender penalties from the insurance carrier, and possibly even an “early withdrawal” penalty from the IRS.

With that in mind, before moving forward with the purchase of life insurance – as well as with accessing funds from the cash value or death benefit on a policy that you already own – discussing various scenarios with a life insurance specialist is highly recommended. Otherwise, you could find that Uncle Sam will receive a significant portion of the cash.

Other Items to Consider When Purchasing Life Insurance

In addition to the taxation of the cash value and/or death benefits when they are received, there are several other items to consider before you commit to purchasing a life insurance policy. These include the following:

Financial strength of the carrier.

Life insurance is oftentimes purchased to help ensure that survivors won’t endure financial hardship. So, it is essential to make sure that the insurance company you purchase a policy from is strong and stable financially, and that it has a good reputation for paying out its policy holders’ claims.

One way to check this is through the ratings that the insurer is given from Standard & Poor’s, A.M. Best, Moody’s, and/or Fitch. You could also check for information about the insurance carrier through the website of the Better Business Bureau (BBB).

Type of carrier.

There are two primary types of life insurance carriers in the marketplace. These are stock and mutual insurance companies.

Stock insurers focus more on generating a profit for their shareholders, while mutual carriers are geared more towards their policy holders.

In addition, while they are not guaranteed, many mutual insurance carriers offer dividends certain permanent life insurance policy holders. These may be taken in cash, added to the policy’s cash value, or used to purchase additional death benefit coverage.

Short or long term needs.

Some life insurance needs are shorter-term, such as making sure that a 15-year home mortgage is paid off if an income earner passes away. Others, such as payment of estate tax or replacing lost retirement income for a surviving spouse, are longer-term.

Many short-term coverage needs can be protected with term life insurance, while the needs that may be indefinite in terms of time period are oftentimes better served with permanent life insurance policies.

Other life insurance coverage in place. Another consideration is whether or not you have other life insurance coverage in place. If, however, this is part of an employee benefit package – and in turn, could be lost if you leave the employer – then this, too, should be taken into consideration.

MEC / Modified Endowment Contract status.

In some cases, a life insurance policy could lose its tax-advantaged status if it becomes a Modified Endowment Contract, or MEC. A modified endowment contract is a designation that is given to cash value life insurance contracts that have exceeded legal tax limits.

If the IRS re-labels a life insurance contract as a MEC, it removes the tax benefits of withdrawals that you can make from the policy. This can happen if you “overfund,” or pay too much in premiums in too short a period of time.

Changing needs.

After you purchase a life insurance policy, it is possible that your needs may change in the future. This could occur if you get married or divorced, face the death of a spouse, have or adopt a child or grandchild, and/or purchase or sell a home or a business. Because of this, it is important that you review your life insurance coverage regularly, and make any changes as needed.

Are You and Your Loved Ones Protected from Life Insurance Taxation?

life insurance protectionLife insurance is an essential component of most any complete financial plan. But not all life insurance policies are exactly the same. So, before you commit to purchasing one, it is important that you first have a good understanding of what your objectives are, and then determine which type of policy will work the best for you and your specific needs.

In addition to just the death benefit protection, life insurance can provide you and/or your loved ones with many tax-related advantages, too. These can include income tax free receipt of the death proceeds, along with tax-deferred growth of the cash value (on permanent policies).

But oftentimes when the IRS provides enticing benefits, it will also take something away. For instance, there are various situations where life insurance proceeds could be taxable – such as estate taxes.

Likewise, the withdrawal of cash value from permanent life insurance policies could be taxable – and could also be grounds for additional surrender charges from the insurance carrier, as well as a 10% early withdrawal penalty from the IRS if you are under the age of 59 ½ when you make such withdrawals.

With all of that in mind, working with a life insurance specialist can be extremely beneficial in putting the right type and amount of protection in place for you – as well as creating an overall plan that could benefit you and your loved ones, both during your lifetime and afterwards.

At Insurance and Estates, we have experts available who can answer all of your questions about life insurance and walk you through various scenarios in order to narrow down which type of coverage – if any – may be right for you.

So, feel free to contact us for a no-cost, no-obligation chat. You can reach us by phone at (877) 787-7558 or you can send us an email with any questions that you may have by going to

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