Do You Get Taxed for Taking Money Out of a Life Insurance Policy

Do You Get Taxed for Taking Money Out of a Life Insurance Policy

Generally, the death benefit from a life insurance policy is income tax-free to the beneficiary, and withdrawals or loans taken from a policy's cash value are often not taxed either — provided you stay within certain limits. Whether you owe taxes depends on how you access the money, the policy type, and your cost basis.

How Withdrawals and Loans Are Taxed

When you surrender a policy or take a withdrawal from the cash value, the IRS taxes only the gains — the amount that exceeds your cost basis. Your cost basis is the total premiums you've paid into the policy. If you withdraw more than your basis, the excess is typically treated as ordinary income. If you withdraw within your basis, it's usually tax-free. Policy loans are generally not taxable as long as the policy remains in force, but if the policy lapses with an outstanding loan, the IRS may treat the loan as a taxable distribution up to the gain portion.

MEC vs. Standard Whole Life and Universal Life

A Modified Endowment Contract, or MEC, loses the favorable tax treatment of a standard life insurance policy. Withdrawals from a MEC are taxed as ordinary income first, and any gains withdrawn may also incur a 10% penalty if taken before age 59½. Standard whole life and universal life policies that pass the seven-pay test keep their tax-advantaged status, so gains withdrawn are taxed only on the excess over your basis.

When the Death Benefit Is Taxed

The death benefit is typically income tax-free, but there are exceptions. If the insured transferred a policy for valuable consideration — meaning it was sold — the proceeds above the cost basis may be taxable. Additionally, if the policy is part of an estate and the estate exceeds federal exemption thresholds, the death benefit could be subject to estate taxes, though this is not an income tax on the beneficiary.

Key Takeaways

• Death benefits are generally income tax-free to beneficiaries.
• Withdrawals are taxed only on gains above your cost basis.
• Policy loans are not taxable unless the policy lapses.
• MEC policies are taxed as ordinary income on gains.
• Selling a policy for value can trigger taxes on the death benefit.

Factors That Affect Your Tax Outcome

Several factors shape whether taking money out of a life insurance policy creates a tax bill: the policy's structure, whether it is a MEC, the amount withdrawn relative to your basis, and how the policy is owned. If the policy is inside a tax-qualified account like an IRA, different rules apply. State taxes also vary, and some states impose inheritance or estate taxes that could affect large payouts. Working with a tax professional helps clarify your specific exposure before you withdraw or borrow against a policy.