Cash value life insurance is generally not taxable as it grows within the policy. However, taxes may apply to withdrawals, loans, or surrenders that exceed the total premium payments made, so it's essential to understand the specific rules and consult a tax advisor for guidance.
Updated June 10, 2024
As you review your life insurance coverage, it's smart to consider how taxes might affect any benefits you or your loved ones receive. For most people using life insurance as a financial cushion in the event a family member's death, taxes might not be an issue. But depending on how you use your policy, you could potentially face tax consequences. Here's what you need to know.
Permanent life insurance policies typically include a cash value, which can be borrowed against and potentially used to pay the premium or purchase an annuity. The cash value has the potential to grow over time and accrue interest. Annual cash value growth in a life insurance policy is not usually taxable.
Withdrawals from a permanent policy can also be tax-friendly, but it's crucial to know the rules and review your strategy with a CPA before taking action. So, when is the cash value of life insurance taxable? Here are a few elements to keep in mind:
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Overfunded life insurance occurs when you pay more money than the minimum premium amount required into the policy. By overfunding permanent life insurance policies, which include whole life and universal life, you can typically grow your cash value. Here are some situations in which you might want to consider overfunding a life insurance policy.
Beneficiaries who receive a death benefit as a lump sum typically do not need to pay income taxes on that payout. However, beneficiaries may have several options available to them, and they could owe taxes on any earnings from a life insurance payout.
Insurance companies often pay interest when beneficiaries refrain from accessing the proceeds of a policy. Those interest earnings are usually reported on each beneficiary's annual tax return and may result in taxes due.
Life insurance is generally exempt from taxes when your beneficiaries are paid the death benefit; your cash value increases; you borrow money from your cash value; you withdraw cash value, but it’s less than what you paid in premiums; or you exchange your life insurance for a different policy or an annuity.
Life insurance can be taxed when your beneficiaries owe estate or inheritance taxes, you cancel or lapse a policy with cash value worth more than you paid, you have an outstanding policy loan when you cancel or lapse your policy or your policy is a modified endowment contract.
For some, receiving a large amount of money — especially after the death of a loved one — can be disorienting. They may need some time to decide what to do with the money, so waiting can help beneficiaries avoid rash decisions.
Meanwhile, other people may choose to take periodic payments from the proceeds of a life insurance policy (instead of taking a lump sum). These payments can reduce the chances of beneficiaries spending all of their money too quickly. Plus, defined payments make it easy to budget during the coming months and years, potentially replacing the monthly income that the deceased family member once contributed. Interest payments are taxable when withdrawn.
There may be other situations that create a tax liability, although many people — especially those who use life insurance simply to protect against the loss of a wage-earning parent — are unlikely to meet those criteria. Still, it can be helpful to speak with your tax advisor and insurance professional before buying or changing a life insurance policy.
Tip
In certain circumstances, the death benefit that life insurance can provide may incur no taxes.
Likewise, policy owners may be able to use the cash value from a policy without owing taxes. However, loans, withdrawals, and surrenders can potentially cause tax consequences, so it's critical to review your plans with a CPA. You may not be able to avoid taxes entirely, but avoiding surprises can make life easier for you and your loved ones.
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