Taxation of Life Insurance Policies

What Gets Taxed

Life insurance premiums paid for a term or whole‑life policy are not deductible. The death benefit paid to beneficiaries is generally exempt from federal income tax. However, if the policy's cash value grows, that growth is taxable when withdrawn or when the policy lapses, unless the policy is a non‑participating policy or a specific tax‑advantaged product.

Premiums and Tax Credits

Premiums themselves do not create a tax deduction. In some states, a portion of premiums may qualify for a state tax credit, but this varies by jurisdiction. Certain high‑risk or high‑net‑worth individuals may qualify for a federal tax credit under the Premium Tax Credit program if they purchase coverage through the Marketplace.

Cash Value Accumulation

Whole‑life and universal life policies accumulate cash value on a tax‑deferred basis. The IRS treats this as a "built‑in" investment: the growth is not taxed while inside the policy. Once a policyholder withdraws cash value or the policy lapses, the amount withdrawn above the total premiums paid becomes taxable income.

Policy Loans

Borrowing against a policy's cash value does not trigger a taxable event. However, if the policy is surrendered or lapses while a loan remains outstanding, the loan amount may be treated as taxable income. The loan interest is not deductible unless it is used for investment purposes.

Estate and Gift Tax Considerations

When a policy is owned by a decedent, the death benefit becomes part of the estate and may be subject to federal estate tax if the value exceeds the exemption threshold ($12.92 million in 2024). If the policy is a gift, it may trigger gift tax rules if the value exceeds the annual exclusion ($17 000 per recipient in 2024).

State Variations

States differ in how they treat policy cash value withdrawals and policy loans. Some states exempt all policy proceeds, while others tax the gains. Reviewing state statutes or consulting a tax professional is essential for accurate planning.