Understanding Taxes on Life Insurance Policies

Why life insurance can be taxable

Most life insurance death benefits are tax‑free, but certain situations cause the proceeds to be subject to income tax. If the policy's cash value grows and you withdraw more than your basis, or if the policy is transferred for value, the IRS treats the excess as taxable income.

Cash value withdrawals and loans

When you tap the policy's cash value, withdrawals up to the total premiums you've paid are generally not taxed. Any amount above that basis is considered earnings and is taxable as ordinary income. Policy loans are not taxable as long as the policy remains in force, but if the loan is not repaid and the policy lapses, the outstanding loan amount may be taxed.

Policy ownership and transfers

Transferring a policy to another person for consideration (a "transfer for value") triggers a taxable event. The death benefit becomes partially taxable, usually calculated as the amount transferred minus the insured's adjusted basis.

Exceptions and exemptions

Beneficiaries receive the death benefit tax‑free if the policy is owned by the insured and no transfer for value occurs. Additionally, the IRS allows a "7‑pay test" for certain policies; if premiums exceed the limit, the policy may be classified as a modified endowment contract (MEC), making distributions taxable.

Key differences by policy type