Is Life Insurance Taxable? What Beneficiaries Need to Know

The General Rule: Life Insurance Death Benefits Are Income Tax-Free

If someone you love has passed away and left you as the beneficiary of a life insurance policy, here is the most important thing to know upfront: in the vast majority of cases, the death benefit you receive is completely free of federal income tax.

This is not a loophole or a special deduction. It is a core feature of life insurance written directly into the tax code. Section 101(a) of the Internal Revenue Code states that proceeds paid by reason of the death of the insured are excluded from the beneficiary's gross income. Whether the payout is $25,000 from a final expense policy or $2 million from a term life policy, the beneficiary does not report it as income and does not owe federal income tax on it.

This tax-free treatment applies regardless of the type of policy — term life, whole life, universal life, or group life through an employer. It applies whether the beneficiary is a spouse, a child, a sibling, a friend, or a trust. And it applies whether the death benefit is paid as a lump sum or in installments (though installments introduce a separate tax issue we will cover below).

That said, there are several important exceptions. While the general rule protects most beneficiaries from taxes, specific situations can make life insurance proceeds partially or fully taxable. Understanding these exceptions is essential for anyone who owns a policy, is named as a beneficiary, or is doing estate planning.

When Life Insurance IS Taxable: The Exceptions

While the death benefit itself is almost always income tax-free, there are six common situations where life insurance can trigger a tax bill. Each one works differently, and some are more likely to affect you than others.

1. Estate Tax on Large Estates

If the policyholder owns the policy at the time of death, the full death benefit is included in their gross estate for federal estate tax purposes. For most Americans, this does not matter — the federal estate tax exemption for 2026 is $13.99 million per individual ($27.98 million for married couples). Only estates exceeding those thresholds owe estate taxes.

But for high-net-worth individuals, a large life insurance policy can push the estate over the exemption threshold. The federal estate tax rate on amounts above the exemption is 40%. So if a $3 million life insurance policy causes an estate to exceed the exemption, the estate could owe $1.2 million in estate taxes on that excess alone.

Important: The current exemption amount is historically high and is scheduled to be cut roughly in half after 2025 under the sunset provisions of the Tax Cuts and Jobs Act, unless Congress acts to extend it. If the exemption drops to approximately $7 million per individual, estate tax exposure on life insurance proceeds becomes relevant for a much larger group of people.

2. Interest on Delayed or Installment Payouts

Some beneficiaries choose to receive the death benefit in installments rather than a lump sum. Others leave the proceeds on deposit with the insurance company to earn interest. In both cases, the original death benefit remains tax-free, but any interest earned on the money is taxable as ordinary income.

For example, if you receive a $500,000 death benefit in annual installments of $55,000 over 10 years, you will receive a total of $550,000 — the $500,000 benefit plus $50,000 in interest. The $500,000 is tax-free. The $50,000 in interest is taxable income, reported to you on a Form 1099-INT each year. If the insurer delays payment and you receive interest for the delay period, that interest is also taxable.

How to avoid this: Take the death benefit as a lump sum. There is no interest to tax if you receive the full amount at once.

3. Employer-Paid Group Life Insurance Over $50,000

Many employers offer group-term life insurance as a workplace benefit. The IRS allows employers to provide up to $50,000 in group-term life coverage tax-free. But if your employer-provided coverage exceeds $50,000, the cost of the excess coverage is treated as taxable income to you, the employee.

This is called imputed income. The IRS uses a table (Table I in Publication 15-B) to calculate the monthly cost of coverage based on your age. The older you are, the higher the imputed cost. This amount shows up on your W-2 each year and increases your taxable income — even though you never received the money as cash. You owe both income tax and FICA taxes on the imputed amount.

To be clear, the death benefit itself is still income tax-free for your beneficiary. The taxable event is the cost of coverage above $50,000 being treated as a benefit to you while you are alive.

4. Selling a Life Insurance Policy (Life Settlements)

If you sell your life insurance policy to a third party — known as a life settlement — the proceeds you receive may be taxable. The tax treatment breaks down into three tiers:

• Up to your cost basis (total premiums paid minus dividends received): Tax-free. This is a return of your own money.
• Between your cost basis and the cash surrender value: Taxed as ordinary income. This represents the inside buildup that has been growing tax-deferred.
• Above the cash surrender value: Taxed as long-term capital gains. This is the premium the buyer pays above the policy's cash value.

Life settlements can be financially worthwhile for seniors who no longer need or can afford their policies, but the tax implications can be significant. A $1 million policy sold for $350,000 by someone who paid $100,000 in premiums with a $120,000 cash surrender value would face ordinary income tax on $20,000 and capital gains tax on $230,000.

5. Cash Value Withdrawals Exceeding Your Basis

Permanent life insurance policies — whole life, universal life, and variable universal life — build cash value over time. You can access this cash value through withdrawals or loans. The tax treatment depends on which method you use and how much you take.

Withdrawals: You can withdraw up to your cost basis (the total premiums you have paid in) without owing any tax. Once you withdraw more than your basis, the excess is taxed as ordinary income. For example, if you paid $80,000 in premiums and your cash value is $120,000, you can withdraw up to $80,000 tax-free. The remaining $40,000 would be taxed as ordinary income.

Policy loans: Borrowing against your cash value is not a taxable event — regardless of how much you borrow — as long as the policy remains active. However, if the policy lapses or is surrendered while a loan is outstanding, the outstanding loan amount is treated as a distribution and can trigger a large tax bill.

Surrendering the policy: If you cancel your policy entirely and receive the cash surrender value, any amount above your cost basis is taxable as ordinary income. The insurer will issue a Form 1099-R for the taxable portion.

6. Transfer-for-Value Rule

The transfer-for-value rule is a lesser-known provision that can strip a life insurance policy of its tax-free death benefit. If a life insurance policy is transferred from one owner to another in exchange for something of value — money, services, or other consideration — the death benefit loses its income tax exemption.

When this rule applies, the beneficiary can only exclude from income the amount the new owner paid for the policy plus any subsequent premiums. The rest of the death benefit is taxed as ordinary income.

There are important exceptions to this rule. Transfers to the following do not trigger the transfer-for-value rule:

• The insured person
• A partner of the insured
• A partnership in which the insured is a partner
• A corporation in which the insured is an officer or shareholder
• Any transfer where the new owner's basis is determined by reference to the transferor's basis (such as a gift)

This rule most commonly comes into play in business situations — such as when a company purchases an employee's personal policy or when business partners buy each other's policies in a cross-purchase agreement that is not structured correctly.

How to Avoid Taxes on Life Insurance

Most people will never owe taxes on life insurance if they follow a few straightforward strategies. Here is how to keep the full death benefit in the hands of your beneficiaries:

• Name a beneficiary directly. Always designate a specific person or trust as your beneficiary rather than your estate. Death benefits paid to a named beneficiary bypass probate and are not directly subject to estate claims. If the benefit is paid to your estate instead, it becomes part of the probate process and counts toward your taxable estate.
• Choose a lump-sum payout. Taking the death benefit as a single lump sum eliminates any interest income that would be taxable under an installment arrangement. The entire amount arrives tax-free.
• Use an ILIT for large estates. If your estate is large enough that life insurance proceeds could push it above the federal estate tax exemption, transferring policy ownership to an irrevocable life insurance trust removes the death benefit from your taxable estate entirely.
• Borrow rather than withdraw from cash value. If you need to access cash value in a permanent policy, taking a policy loan rather than a withdrawal avoids creating a taxable event. Just make sure the policy stays in force — if it lapses with an outstanding loan, the tax consequences can be severe.
• Use a 1035 exchange when switching policies. If you want to replace one life insurance policy with another, a 1035 exchange allows you to transfer the cash value without triggering taxes. Cashing out first and then buying a new policy creates an unnecessary taxable event.
• Avoid transferring your policy for value. Do not sell or transfer ownership of your policy to someone else for compensation unless the transaction falls within one of the exceptions to the transfer-for-value rule. Gifting a policy to a trust or family member is generally safe; selling it to an unrelated third party may not be.

Irrevocable Life Insurance Trusts (ILITs) for Estate Planning

For high-net-worth individuals, an irrevocable life insurance trust is the single most effective tool for keeping life insurance proceeds out of a taxable estate. Here is how it works.

An ILIT is a trust that you create during your lifetime specifically to own your life insurance policy. Once the trust is established and the policy is transferred into it (or the trust purchases a new policy), you no longer own the policy. Because you do not own it, the death benefit is not part of your estate when you die. Your beneficiaries still receive the full payout — the trust distributes it according to the terms you set when creating it — but the IRS cannot count it toward your taxable estate.

There are key rules and trade-offs to understand:

• The three-year rule. If you transfer an existing policy to an ILIT, you must survive at least three years after the transfer. If you die within three years, the IRS pulls the death benefit back into your estate as if the transfer never happened. To avoid this, many estate planners recommend having the ILIT purchase a new policy rather than transferring an existing one.
• Irrevocability means permanent. Once you set up the trust, you cannot change it, take the policy back, borrow against the cash value, or alter the beneficiaries without the consent of all trust beneficiaries. This is a significant commitment.
• Premium payments require Crummey notices. When you make gifts to the trust to cover premium payments, the trust must send written notices to beneficiaries giving them a temporary right to withdraw the gifted amount. These Crummey notices ensure the gifts qualify for the annual gift tax exclusion ($18,000 per beneficiary in 2026).
• Professional setup is essential. An ILIT must be drafted by an experienced estate planning attorney to ensure it is structured correctly. Errors in drafting, funding, or administration can invalidate the trust's estate tax benefits entirely.

An ILIT is generally worth considering if your estate is approaching or exceeds the federal estate tax exemption, you own a policy with a death benefit of $1 million or more, or you expect the estate tax exemption to decrease in the future.

Tax Treatment of Cash Value Growth

One of the key advantages of permanent life insurance — whole life, universal life, and variable universal life — is that the cash value grows tax-deferred. This means you do not pay taxes on the gains each year as they accumulate, unlike a taxable brokerage account where dividends, interest, and realized capital gains are taxed annually.

Here is how the tax treatment works at each stage of the policy's life:

• While the policy is active: Cash value growth is tax-deferred. Whether it grows through guaranteed interest (whole life), index-linked crediting (indexed universal life), or sub-account investments (variable universal life), you owe nothing to the IRS as long as the money stays inside the policy.
• When you take withdrawals: Withdrawals up to your basis are tax-free (FIFO — first in, first out). Withdrawals exceeding your basis are taxed as ordinary income.
• When you take policy loans: Not taxable, regardless of the amount, as long as the policy remains in force. The loan accrues interest that is charged against your cash value.
• When you surrender the policy: The cash surrender value minus your cost basis is taxed as ordinary income. Outstanding loans are added to the taxable amount.
• When the insured dies: All accumulated cash value is included in the death benefit and passes to the beneficiary income tax-free. The tax-deferred gains are never taxed. This is the most powerful tax advantage of permanent life insurance.

MEC warning: If a policy is overfunded relative to its death benefit, it may be classified as a modified endowment contract (MEC) under Section 7702A of the tax code. MECs lose some of their tax advantages — specifically, withdrawals and loans from a MEC are taxed on a last-in, first-out (LIFO) basis, meaning gains come out first and are taxed as ordinary income. A 10% penalty may also apply to withdrawals before age 59 1/2. The death benefit remains income tax-free, but the living benefits are significantly less favorable.

1035 Exchanges: Swapping Policies Without a Tax Hit

Section 1035 of the Internal Revenue Code allows you to exchange one life insurance policy for another — or for an annuity — without recognizing any taxable gain. This is similar in concept to a 1031 exchange in real estate, but for insurance products.

A 1035 exchange is useful when:

• Your current policy has high fees and you want to switch to a more cost-efficient policy
• You want to change from one type of permanent policy to another (such as whole life to universal life)
• You no longer need life insurance but want to convert the cash value into an annuity for retirement income
• Your current policy has accumulated significant gains that would be taxed if you surrendered it

The permitted exchanges under Section 1035 are:

• Life insurance policy to another life insurance policy
• Life insurance policy to an annuity
• Annuity to another annuity
• Long-term care insurance to long-term care insurance

Important: You cannot exchange an annuity for a life insurance policy — the exchange must flow in a direction that does not create new death benefit from what was a savings product. The exchange must also involve the same insured person, and the funds must transfer directly between insurers. If you receive the cash and then purchase a new policy, it is not a 1035 exchange — it is a surrender followed by a new purchase, and the gains on the surrender will be taxed.

State Taxes on Life Insurance

Everything discussed above relates to federal taxes. State tax treatment varies and can add another layer of complexity.

Most states follow the federal rule and do not tax life insurance death benefits as income. However, a handful of states impose their own estate or inheritance taxes with lower thresholds than the federal exemption. As of 2026, twelve states and the District of Columbia impose a state-level estate tax, and six states impose an inheritance tax. Maryland imposes both.

States with estate taxes typically have exemption thresholds well below the federal level — ranging from about $1 million (Oregon, Massachusetts) to $6.94 million (New York). If you live in one of these states, life insurance owned by the deceased could be subject to state estate tax even if the federal exemption protects you. An ILIT can help with state estate taxes just as it does with federal estate taxes.

States with inheritance taxes (Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania) tax the recipient based on their relationship to the deceased. Spouses are almost always exempt. Children and direct descendants often face lower rates or higher exemptions. More distant relatives and non-relatives typically face the highest rates.

The Bottom Line

For the vast majority of Americans, life insurance death benefits are received completely income tax-free. This is one of the strongest tax advantages in the entire tax code, and it is the reason life insurance remains a cornerstone of financial planning.

The exceptions — estate tax on large estates, interest on installment payouts, imputed income on employer-provided coverage over $50,000, gains on life settlements, cash value withdrawals above basis, and the transfer-for-value rule — affect a relatively small number of people. But if you fall into one of those categories, the tax consequences can be substantial.

The good news is that every one of these tax situations is manageable with proper planning. Name a beneficiary directly. Take payouts as a lump sum. Use an ILIT if your estate is large. Borrow against cash value rather than withdrawing. Use 1035 exchanges when switching policies. Avoid unnecessary transfers for value.

If your situation involves a large estate, a business-owned policy, or a permanent policy with significant cash value, consult a tax professional or estate planning attorney. The cost of good advice is a fraction of the taxes you could owe by making an avoidable mistake.