Skip to main content

7.1 Taxation of Personal Life Insurance

Premiums​

For individuals, life insurance premiums are treated as personal expenses and therefore are not tax deductible. These premiums are paid with after-tax dollars, which establishes the cost basis of the policy for tax purposes.

Cash Values​

In a cash value life insurance policy, the policy's cash value typically increases each year. This growth results from both premium contributions and interest or investment gains credited to the policy. These earnings are not taxed when they are credited, allowing the cash value to grow on a tax-deferred basis.

Tax-deferred treatment continues until one of the following events occurs:

  • The policy is surrendered
  • The policy is transferred for value (sold or assigned)
  • The policy no longer qualifies as a life insurance contract under IRS rules

If the policyowner surrenders the policy, sells it, or withdraws funds, any amount received that exceeds the total premiums paid (cost basis) is taxed as ordinary income. This principle is commonly known as the Cost Recovery Rule.

When funds are withdrawn from a cash value life insurance policy, withdrawals up to the policy's cost basis are generally tax free. This follows the First-In, First-Out (FIFO) rule, meaning premiums paid into the policy are considered to be withdrawn first. The cost basis equals the total premiums paid into the policy minus any dividends or previous withdrawals. Any withdrawal that exceeds the cost basis is taxed as ordinary income.

If a cash value policy is surrendered, any gain is subject to federal and possibly state income tax. The gain is calculated as the total cash value received, plus any outstanding policy loans, minus the policy's cost basis.

When a policy matures, the accumulated value may be paid out either as a lump sum or through one of the insurer's settlement options. As with other distributions made while the insured is alive, any amount received that exceeds the policy's cost basis is treated as taxable ordinary income.

Policy Loans​

When a policyowner borrows against the cash value of a life insurance policy, the loan proceeds are not considered taxable income. This remains true even if the loan amount exceeds the total premiums paid into the policy. As long as the policy remains in force, the loan itself is not subject to taxation.

However, if the policy lapses or is surrendered while a loan is outstanding, the portion of the loan that exceeds the policy's cost basis (total premiums paid minus prior withdrawals or dividends) will be treated as taxable ordinary income.

Additionally, the interest paid on a life insurance policy loan is not tax-deductible for income tax purposes.

Dividends​

A dividend from a participating insurance company represents a portion of the premium returned to the policyowner when the insurer experiences lower-than-expected mortality costs, expenses, or higher investment earnings. These dividends are distributed from the insurer's surplus earnings for that year. Because dividends are considered a return of excess premium, they are generally not taxable.

However, if dividends are left on deposit with the insurer to earn interest, the interest earned is taxable as ordinary income in the year it is credited.

In addition, if the total dividends received exceed the total premiums paid for the policy, the amount above the premium paid is considered taxable income.

Death Benefit Proceeds (Claims)​

The death benefit, or face amount, of a life insurance policy is generally not taxable as income when it is paid to a named beneficiary as a lump-sum payment.

However, if the beneficiary elects to receive the proceeds through a settlement option rather than a lump sum, any interest or earnings portion included in the payments will be taxed as ordinary income.

Estate Taxes and Benefits Included​

Life insurance proceeds may become part of the insured's estate, either by design or by default. This may occur if the policyowner names the estate as the beneficiary, or if no beneficiary is living at the time of the insured's death, causing the proceeds to be paid directly to the estate.

When this occurs, the death benefit is included in the total value of the estate and may be subject to federal estate taxation, depending on the size of the estate.

If the policyowner and the insured are the same person, the life insurance proceeds are generally included in the insured's estate for estate tax purposes. For this reason, it is often recommended that someone other than the insured be designated as the policyowner to help avoid having the proceeds included in the insured's taxable estate.

Accelerated Death Benefits Payments received through an accelerated death benefit are generally tax free to the recipient if the benefit qualifies under IRS guidelines. To be considered a qualified accelerated benefit, the following conditions must be met:

  • A physician must certify that the insured has a life expectancy of 24 months or less.
  • The amount of the accelerated benefit must be at least equal to the present value of the remaining death benefit after the payment is made.
  • The insurer must provide periodic reports to the insured showing the amount of benefits paid and the remaining death benefit available under the policy.

Quiz​

1. How are life insurance premiums generally treated for individual income tax purposes?

A. Fully tax deductible

B. Partially tax deductible

C. Considered a personal expense and not tax deductible

D. Deductible only when paid annually

Correct Answer: C

Rationale: Life insurance premiums paid by individuals are considered personal expenses and therefore are not tax deductible. These premiums are paid with after-tax dollars, which establishes the cost basis in the policy for tax purposes.

2. What tax treatment applies to the growth of cash value inside a life insurance policy?

A. Taxed annually as investment income

B. Taxed only if dividends are paid

C. Tax-deferred until distribution

D. Always tax free

Correct Answer: C

Rationale: The interest or investment gains credited to a life insurance policy's cash value accumulate on a tax-deferred basis. Taxes generally apply only when the funds are withdrawn, surrendered, or otherwise distributed beyond the policy's cost basis.

3. Under the First-In, First-Out (FIFO) rule for life insurance withdrawals, which funds are considered withdrawn first?

A. Interest earnings

B. Dividends

C. Policy loans

D. Premiums paid into the policy

Correct Answer: D

Rationale: The FIFO rule treats withdrawals from a life insurance policy as coming first from the policy's cost basis (premiums paid). Withdrawals up to this amount are tax free, while amounts exceeding the cost basis are taxed as ordinary income.

4. How are life insurance policy loans generally taxed while the policy remains in force?

A. Fully taxable as income

B. Taxed as capital gains

C. Not taxable

D. Taxed only if interest is paid

Correct Answer: C

Rationale: Policy loans taken against the cash value of a life insurance policy are not considered taxable income, as long as the policy remains active. However, if the policy lapses with an outstanding loan, the amount exceeding the policy's cost basis becomes taxable as ordinary income.

5. Which statement correctly describes the taxation of life insurance death benefits?

A. Always taxed as ordinary income

B. Tax free only when paid to a spouse

C. Generally tax free when paid as a lump sum to a beneficiary

D. Taxed only if the policy has cash value

Correct Answer: C

Rationale: Life insurance death benefit proceeds are generally not taxable as income when paid to a named beneficiary as a lump sum. However, if the proceeds are paid through a settlement option, any interest portion of the payments will be taxed as ordinary income.