Is life insurance taxable?

You’ve planned, you’ve paid your premiums and you’ve done an honorable thing by protecting your family with life insurance. But now you’re facing a question you didn’t expect: will taxes take a bite out of that payout when your loved ones need it most? The truth is, while life insurance is usually tax-free, there are a few situations where the IRS could get involved — especially if your policy has grown in value or is part of a larger estate. That’s where we come in. At Bankrate, our life insurance team, which includes licensed agents, is here to help you make sense of the fine print, so you can keep more of your money where it belongs — with the people you aim to protect.

Is life insurance taxable?

Life insurance is often seen as a reliable way to provide for loved ones after you’re gone, and one of its biggest advantages is the tax relief it offers. Typically, the death benefit your beneficiaries receive isn’t taxed as income, meaning they get the full amount to use for expenses like paying off debts, covering funeral costs or securing their future. But there are a few situations where life insurance is taxed, and it’s important to know when that might happen.

Lump sum vs. installment payments

A lump sum payout is the default death benefit payment method. However, your loved ones could opt to choose to receive the life insurance payout in installments instead. The principal is kept with the insurer to earn you interest but these gains may be considered taxable income, even though the original death benefit is not. 

Estate as beneficiary

Another exception occurs when a policyholder leaves the death benefit to their estate instead of directly naming a person as the beneficiary. This could happen involuntarily if the owner doesn’t name a contingent beneficiary and the primary beneficiary and policy owner die simultaneously. When there is no one named on the policy able to claim the proceeds, it goes into probate where it typically gets paid to the estate. If the estate’s total value is large enough, it may trigger estate taxes, reducing what your heirs ultimately receive.

Borrowing and withdrawing cash values

Cash value life insurance, like whole or universal life, also has its own tax rules. Policyholders can generally borrow or withdraw money from the policy’s cash value, and as long as they don’t take out more than they’ve paid in, those withdrawals are usually tax-free. However, if there are unpaid loans against the policy, they will be deducted from the death benefit, meaning your beneficiaries get less.

Modified endowment contracts

If the policy is a modified endowment contract (MEC), taxes are different. For tax purposes, withdrawals are on a last-in, first-out (LIFO) basis. This means that all withdrawals are treated as taxable income until they cumulatively equal all interest earnings in the contract.

These are just a few of the situations where taxes could impact your life insurance proceeds. In the sections ahead, we’ll dive deeper into more scenarios to help you fully understand how taxes might affect your life insurance and how to potentially avoid them.

Term life insurance taxation

Term life insurance is often the cheapest life insurance, especially when you’re young and healthy. When it comes to term life insurance, taxation is generally straightforward because there’s no cash value component involved. The primary concern with taxation revolves around the death benefit payout and certain specific situations, like selling the policy. Luckily, most of these scenarios can be avoided with proper planning. Let’s break down a few key instances when term life insurance might be taxed.

Tax trouble with interest on installments 

If the death benefit from a term life insurance policy is paid out in installments rather than as a lump sum, it may come with a hidden tax surprise. The death benefit itself is typically not taxed, but any interest that accumulates on those installment payments will be taxed as regular income. If the payout is spread over time, your beneficiaries should be prepared to report the interest on their taxes.

The Goodman Triangle: When life insurance becomes a gift tax headache

A lesser-known tax issue can arise in what’s called a Goodman Triangle. This occurs when three different individuals are involved in a life insurance policy — one person is the policy owner, another is the insured and a third is the beneficiary. In this scenario, the IRS could view the death benefit as a gift from the policy owner to the beneficiary, triggering a gift tax if the amount exceeds the annual exclusion limit, which is $19,000 in 2025. To avoid this complication, many financial advisors suggest that only two parties be involved in the policy.

Selling your term life insurance policy? Be ready for income and capital gains taxes

Selling a life insurance policy, also known as a life settlement, might seem like a good option if you no longer need the coverage. However, doing so can trigger income and capital gains taxes. If you sell your policy for more than what you’ve paid in premiums, the gain on that amount could be taxed. Here’s a simplified explanation of the taxation of life insurance policy sales:

• The portion of the sale amount you receive that is equal to what you’ve paid in premiums (your “cost basis”) will not be taxed.
• The portion that exceeds your cost basis, but is less than the cash value of the policy, is subject to income tax.
• Lastly, any amount above the cash value is subject to capital tax gains.

Additionally, the new owner of the policy may face taxes on any death benefit they receive that exceeds what they paid for the policy, plus any premiums they’ve continued to pay.

Death benefit and estate taxes: What heirs need to know

If you own a term life insurance policy when you pass away, the death benefit becomes part of your taxable estate. This could push your estate’s total value above the federal estate tax exemption ($13.99 million in 2025), triggering estate taxes. While this generally impacts only high-net-worth individuals, some states have a state estate tax as well and are typically lower thresholds, so it’s important to factor that into your planning. Working with an estate planner can help minimize these tax implications and ensure your loved ones receive as much of the death benefit as possible.

Permanent life insurance taxation

Permanent life insurance policies, which provide lifetime coverage, are usually more expensive than term life policies. While the cost of life insurance depends on many personal and policy-related factors, comparing quotes can help you find the most affordable policy for your situation.

When it comes to permanent life insurance policies, the tax implications can get a bit more complicated due to the cash value component. While many of the tax concerns that apply to term life insurance also apply here, there are additional considerations when dealing with withdrawals, policy loans and dividends. Let’s break down the key scenarios.

Withdrawing more than your cost basis? Get ready for income taxes

If you decide to make a withdrawal from a universal life insurance policy, it’s important to know that the IRS will only tax the portion that exceeds your cost basis (the total amount of premiums you’ve paid into the policy). The withdrawal amount up to your cost basis is tax-free, but anything above that is considered taxable income and will need to be reported.

Policy lapse with outstanding loans? It could trigger taxable income

Taking out loans against your permanent life insurance policy allows you to borrow against the cash value without immediately worrying about taxes. However, if your policy lapses — meaning it’s no longer active due to unpaid premiums or insufficient cash value — any outstanding loan balance that exceeds what you’ve paid into the policy (your cost basis) will be treated as taxable income by the IRS.

Surrendering your policy? Beware of taxes on excess cash value

Surrendering your permanent life insurance policy might seem like a good way to access immediate cash, but it can come with tax implications. When you surrender the policy, the cash surrender value (CSV) is the amount you’ll receive after any fees are deducted. However, if the CSV is higher than the amount of premiums you’ve paid into the policy (your cost basis), the excess is taxable as ordinary income.

Participating whole life policy? Interest earned on dividends is taxable

Participating whole life insurance policies sometimes pay dividends to policyholders based on the company’s financial performance. These dividends can be left in the policy to earn interest, effectively growing the policy’s cash value over time. While the dividends themselves aren’t taxed, the interest earned on those dividends is considered taxable income and must be reported. The insurance company will issue a 1099-INT at the end of the year.

How to avoid paying life insurance taxes

Life insurance is designed to offer financial security, not surprise tax bills. While most payouts pass to your beneficiaries tax-free, there are a few situations that could trigger IRS involvement if you’re not careful. The good news? With a little planning, many of these tax pitfalls can be sidestepped entirely. Here are some potential smart moves to help reduce or eliminate the chance of your life insurance proceeds getting taxed:

Putting these strategies into play can help ensure your policy delivers its full value when it matters most. From naming the right beneficiaries to transferring ownership at the right time, small details can make a big difference. As life changes — marriage, divorce, kids or even a new financial plan — it’s worth checking in on your policy so it keeps working in your favor. A little foresight today could save your loved ones from an unexpected tax hit down the line.

Frequently asked questions

• Do you have to pay taxes on money received as a beneficiary?

  Generally, the proceeds from a life insurance policy that you receive as the beneficiary are not considered gross income and do not have to be reported on your income taxes. However, any interest earned is taxable and should be reported.

• How can I tell if my life insurance proceeds are taxable?

  Although life insurance proceeds are usually tax-free, this isn’t the case 100 percent of the time. This tool from the IRS can help you determine if you have to pay taxes on a life insurance payout.

• Do you get a 1099 for life insurance proceeds?

  If you receive life insurance proceeds, you probably won’t receive a 1099 form from the IRS. Life insurance death benefits aren’t usually considered taxable income, so it doesn’t need to be reported on your state or federal income taxes.

• Are life insurance premiums tax deductible?

  Life insurance premiums are typically not tax deductible for personal policies. However, there are a few exceptions. If you gift a life insurance policy to a charity and continue to pay the premiums, those payments are generally considered charitable donations and may be tax deductible. Additionally, if you own a business and provide life insurance for your employees, the premiums you pay might be tax deductible as a business expense. To fully understand your specific situation, it’s always a good idea to consult with a tax professional to ensure you’re maximizing any potential life insurance tax benefits while staying compliant with the law.

• Can life insurance proceeds be garnished if you have debt when you die?

  Life insurance proceeds generally cannot be garnished to pay off your debt when you die as long as you’ve named an individual as your beneficiary. However, if your estate is named as the beneficiary — either because you didn’t name a beneficiary or because your chosen beneficiary passed away before you — those proceeds may go through probate. During probate, creditors can make claims against the estate, which means your life insurance payout could be used to cover debts. To avoid this, it’s important to regularly review your policy and ensure that your beneficiary designations are up-to-date.