You have planned, you have paid your premiums and you have done something honorable by protecting your family with life insurance. But now you’re facing a question you didn’t expect: when your loved one needs it the most, does tax take a sip from that payment? The truth is that while life insurance is usually tax-free, there are some situations where the IRS can be involved. Especially if your insurance is more valuable or is part of a larger property. That’s where we come. At Bankrate, a life insurance team, including licensed agents, is here to help you understand fine print.
Are life insurance taxed?
Life insurance is often seen as a reliable way to offer your loved one after you’re gone, and one of its biggest advantages is the tax mitigation it offers. Usually, the profits of deaths received by beneficiaries are not taxed as income. This means that the entire amount will be used for expenses such as repayment of debt, covering funeral costs, and securing future. However, there are some situations where life insurance is taxed, and it is important to know when that will happen.
Payment of lump sum and installment payments
Lunch payment is the default method of payment of death benefits. However, your loved one can choose to opt to receive life insurance payments in installments instead. The principal is kept with the insurance company, but these benefits may be considered taxable income, even though the original death benefit is not.
Real estate as a beneficiary
Another exception occurs when the policyholder leaves the death benefit on the property rather than naming the person as a direct beneficiary. This can happen involuntarily if the owner is not dying at the same time, the main beneficiary and the policyholder. If no one has a name for a policy that can claim revenue, it usually goes to probate if it is where the property is paid. If the total amount of your property is large enough, it can cause real estate taxes and reduce what your heirs will ultimately receive.
Borrowing and withdrawing cash value
Cash-valued life insurance also has its own tax rules, such as overall and universal life. Policyholders are generally able to borrow or withdraw money from the cash value of the policy. Also, these withdrawals are usually tax-free, unless they are taken away more than you paid. However, if there are unpaid loans for the policy, they will be deducted from the death benefit. This means fewer beneficiaries.
Amended Fund Agreement
If the policy is an amended donation agreement (MEC), the taxes will vary. For tax purposes, withdrawal is the final first (LIFO) basis. This means that all withdrawals will be treated as taxable income until they are cumulatively equal to all interest income in the contract.
These are just a few of the situations where taxes can affect life insurance revenue. Future sections will help you dig deeper into more scenarios and fully understand how taxes affect life insurance and how to potentially avoid them.
Life insurance tax
Term life insurance is the cheapest life insurance, especially if you are young and healthy. Taxation is generally easy when it comes to term life insurance, as there is no component of cash value involved. The main taxation concerns revolve around specific circumstances, such as payment of death benefits and selling policies. Fortunately, most of these scenarios can be avoided with a proper plan. Let’s break down some important cases that could potentially be taxed on term life insurance.
Tax issues with interest in installments
Benefits of death may bring hidden tax surprises if the life insurance policy is paid in installments rather than as a lump sum. Normally, death benefits themselves are not taxed, but the interest accumulated on those installments is taxed as normal income. If payments are spread out over time, beneficiaries must prepare to report tax interest.
Goodman Triangle: When Life Insurance Gets a Gift Tax Headache
Less known tax issues can arise in what is called the Goodman triangle. This occurs when three different individuals are involved in a life insurance policy. One is a policyholder, another is an insured, and the third is a beneficiary. In this scenario, the IRS can view death benefits as a gift from policyholders to beneficiaries, causing gift tax if they exceed the 2025 annual exclusion limit.
Selling your term life insurance? Prepare for income and capital gains tax
Selling life insurance, also known as life settlement, may seem like a good option if you no longer need coverage. However, doing so can lead to income and capital gains taxes. If you sell a policy that is more than what you paid with premiums, the profits of that amount could be taxed. This is a simplified explanation of the taxation of the sale of life insurance contracts.
- The portion of the sale amount you receive is equal to what you paid on your premium (your “cost basis”).
- Any portion of your cost base that is beyond your cost base but less than the cash value of your policy will be subject to income tax.
- Finally, any amounts above the cash value are subject to capital tax profits.
Additionally, new owners of the policy may face taxes above the premiums they paid, in addition to death benefits beyond what they paid for the policy.
Death benefits and real estate tax: What heirs need to know
If you own a life insurance policy at the time of your death, your death benefit will be part of the property that is taxable. This could result in the total property amount exceeding the federal property tax exemption ($13.99 million in 2025), causing real estate taxes. This generally affects only high-net individuals, but some states also have state property taxes, which are usually lower thresholds, so it is important to consider that in your plan. Working with a real estate planner will help you minimize these tax impacts and ensure that your loved one receives as much death benefit as possible.
Permanent Life Insurance Tax
Permanent life insurance that offers lifetime coverage is usually more expensive than term life insurance. The cost of life insurance depends on many personal and insurance contract-related factors, but comparing estimates will help you find the most affordable insurance in your situation.
When it comes to permanent life insurance policies, the cash value factor can make the tax impact a little more complicated. Many of the tax concerns covered by term life insurance also apply here, but there are additional considerations when dealing with withdrawals, insurance contract loans and dividends. Let’s break down important scenarios.
Would you like to withdraw more than your cost base? Prepare for income tax
If you decide to withdraw from universal life insurance, it is important to know that the IRS will only tax parts that exceed your cost base (the total amount of premiums you paid for your insurance policy). The withdrawal amount up to your cost base is tax-free, but anything more than that is considered taxable income and must be reported.
Will a good loan expire your policy? It can cause taxable income
By lending to permanent life insurance policies, you can immediately borrow against cash value without worrying about taxes. However, if your insurance policy expires (which are inactive due to insufficient premiums and cash value, but are not paid in excess of what you paid in the policy (cost-based) will be treated as taxable income by the IRS.
Will you surrender your policy? Beware of taxes on excess cash value
Suspending your permanent life insurance may seem like a good way to access immediate cash, but it can have tax implications. If you abandon your policy, your cash surrender value (CSV) is the amount you receive after the fee has been deducted. However, if the CSV is higher than the premiums paid for the policy (cost-based), the excess will be taxed as normal income.
Are you participating in the participating policies? Interest earned through dividends will be taxed
Participating all life insurance policies may pay dividends to policyholders based on the company’s financial performance. These dividends are left in the policy to earn interest and can effectively increase the cash value of the policy over time. Dividends themselves are not taxed, but the interest earned from those dividends is considered taxable income and must be reported. The insurance company will issue 1099 inches at the end of the year.
How to avoid paying life insurance taxes
Life insurance is designed to provide financial security rather than surprise tax bills. Most payouts pass the beneficiary with tax exemptions, but there are some situations that can cause IRS involvement if not careful. Good news? With a little planning, many of these tax pitfalls can be avoided entirely. Here we present potential smart moves that can help reduce or eliminate the likelihood that life insurance revenues will be taxed.
| strategy | How to avoid taxes |
|---|---|
| Please choose to pay in one lump sum | Death benefits income remains tax-free. Avoid installments and avoid taxable interest. |
| Avoid the Goodman triangle | Prevent gift tax by making the insured and the owner or the owner and beneficiary the same person. |
| Use an irrevocable life insurance trust (ILIT) | We will protect death benefits from taxable properties if certain rules are met. Make sure the policy is forwarded to ILIT at least three years before death. |
| Please suppress policy loans | Prevents taxable income from policy loans by monitoring your loan balance and ensuring that your policy does not expire. |
| Early transfer of ownership | By transferring ownership of the policy in advance (more than three years before death), you will be able to block the policy from taxable real estate. |
| Check your beneficiaries regularly | Make sure your property is not named as a beneficiary and name it an accidental beneficiary to prevent property taxes. We regularly review and update beneficiaries as lifestyle changes occur. |
Creating these strategies will help you ensure that your policy delivers its full value when it matters most. From naming the right beneficiary to transferring ownership at the right time, small details can make a big difference. Whether it’s marriage, divorce, children, or even new financial plans, it’s worth checking out your policies as your life changes, so it will continue to work in your favor. A little visionary today can save your loved one from an unexpected tax blow.
