Is Cash Value Life Insurance Taxable? | 2024 Guide (2024)

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Are Cash Value Life Insurance Proceeds Taxable?

Similar to proceeds of other life insurance policies, the income from a cash value life insurance policy isn’t taxable when taken as a lump sum. Beneficiaries can accept the full death benefit payout of their life insurance policy tax-free. The beneficiary only receives your death benefit amount, not the balance of your cash value. Most cash value policies return unused cash value to the life insurance company at the insured person’s death.

Not all beneficiaries take a lump sum death benefit payment. Many life insurance companies also offer installment payments or annuities instead of lump sum payments. Installment payouts sometimes make it easier for beneficiaries to deal with their sudden influx of money as they cope with the death of their loved one. The downside to an installment payment is the beneficiary usually will have to pay taxes on any interest earned on the remaining benefit. For example, let’s say a beneficiary chooses to get a $500,000 death benefit in monthly payments of $10,000. The death benefit earns interest of $100 per month. Your child would owe taxes on the $1,200 in annual interest earnings ($100 a month for 12 months).

Estate Taxes on Life Insurance Policies

The Internal Revenue Service also taxes cash value life insurance proceeds if they go to a taxable estate. This happens most often if your beneficiary passes away before you or if you fail to name a beneficiary.

Say you name your spouse as your beneficiary and your spouse dies before you. And you forget to name a new beneficiary on your policy. When you die, your death benefit proceeds go to your estate, making them taxable in many cases. Depending on the value of your estate and the state estate taxes where you live, this can create significant tax consequences.

When Is Cash Value Life Insurance Taxable?

The earnings on the cash value of your life insurance policy usually grow tax-free or tax-deferred, but you might owe taxes if you withdraw the money. You’ll generally owe taxes on money earned from investment or interest gains, known as your “above basis” amount. Money that accrues from your premium payments (your “policy basis”) is typically not taxable.

But there are occasions when you may have to pay taxes on a cash value. They include:

Selling Your Life Insurance Policy

Did you know you can sell your life insurance policy? Some policyholders sell their policies — often to an investor — for an immediate cash benefit. Maybe you don’t need your policy anymore or maybe you need money to cover urgent expenses. An investor who buys your policy pays the premiums and becomes the beneficiary. The investor collects the full death benefit when you pass away.

There are two types of in-force life insurance sales:

  • Viatical settlements: A viatical settlement is the sale of a policy by a terminally ill person to an investor. For example, a cancer patient may need money now to cover their expensive medical bills.
  • Life settlements: Life settlements involve selling a policy to an investor, but the seller is usually healthy. A healthy senior might sell their policy because of many reasons, such as to cover rising costs of living or to get rid of the expense of insurance premiums.

Viatical settlements typically come with much higher payout offers than life settlements. Viatical settlement investors recognize their investment is likely to pay off sooner than a life settlement, as someone with a terminal illness may die before someone who is healthy.

There’s also a major difference in tax benefits of a viatical settlement versus a life settlement. Proceeds from selling your insurance policy in a viatical settlement are considered a type of death benefit payout and not taxable. But life settlement payments are considered taxable income, and sellers probably will owe income taxes on some of the proceeds.

Outstanding Loan on Cash Value Policy

One of the benefits of permanent life insurance like whole life insurance or universal life insurance is the ability to borrow against the cash value. Loans against the cash value aren’t taxable while the policy is in force. But if your policy ends and you still have an outstanding loan balance, you may have to pay taxes on part of the loan amount. You might lose life insurance coverage for several reasons, such as failure to pay premiums and the policy lapses or you decide to surrender the policy.

Luckily, you won’t have to pay taxes on the full amount of your cash value policy loan. The taxable portion of your loan amount is only what’s above the basis — meaning interest or investment earnings. The money you put into your cash value through premium payments isn’t taxable, even if your policy ends with an outstanding loan balance.

For instance, you borrow $50,000 against your policy’s cash value account. Of this loan amount, $45,000 came from premium payments you made over the years. The other $5,000 comes from interest and investment earnings, meaning it’s above basis. You won’t pay taxes on any part of your loan so long as the policy is in force. If you suddenly can’t afford your life insurance premiums and your policy lapses. With the policy terminated, you’ll owe taxes on the $5,000 you borrowed above basis.

Surrendering Your Life Insurance Policy

Policyowners of a cash value life insurance policy can surrender it to the insurance company for a cash payout. Some reasons you might want to surrender a life insurance policy include:

  • Not needing coverage: You might not need a life insurance policy if you no longer have people who rely on you financially, such as a spouse or children.
  • Can’t afford premiums: You may want to surrender a policy when you can no longer afford the premiums to keep it in force and want cheap life insurance instead. Some policyholders switch to a different type of policy, such as a no medical exam term life insurance policy.

The exact amount — or cash surrender value — of the policy depends on how much cash value you’ve accrued and any outstanding loan balances you carry. Most policies also have a surrender fee that the insurance company charges when you surrender a contract. Surrender fees tend to go down over time and often phase out over the life of the policy.

Similar to ending a life insurance contract with an outstanding loan balance, there are tax implications on any cash value proceeds above cost basis if you surrender your policy. For example, your surrender value is $30,000, and $3,000 of that is from interest and investment earnings. You’ll pay taxes on the $3,000 above basis, but not on the other $27,000.

Withdrawing Funds From Cash Value

A policy loan isn’t the only way to access your cash value. You can withdraw money from your cash value balance without having to pay it back. The downside, however, is that you’ll almost certainly reduce the life insurance death benefit. In some cases, you might cause the policy to lapse with withdrawals.

Just like policy loans and the surrender value, the IRS only taxes you on distributions you make above the amount you’ve paid into your cash value through premiums. That means if you have $20,000 of cash value and earned $1,000 of that in interest or investments, you could take out $19,000 tax-free.

How to Avoid Tax on Life Insurance Cash Value

The easiest way to avoid paying taxes on the cash value component of a life insurance policy is to only take out as much as you’ve put into the policy through premiums. Most people will only pay taxes on cash value when they distribute over their cost basis. In general, you can expect to owe taxes if you take out interest earnings or investment gains.

There are two exceptions to this, however:

  • Taking out a loan against your cash value
  • Paying too much money into your policy

The IRS won’t tax you on your loan proceeds if you borrow against your cash value account — even if you borrow above basis. The key to avoiding taxes on cash value when you have a policy loan is to make sure you keep your policy in force. Letting your policy lapse or surrounding it with an outstanding loan balance could mean you’re liable for taxes on gains.

Taking out too much of your cash value could lead to taxable income, but so can putting too much money into your policy. Permanent life insurance policies let you use cash value as a tax-deferred investment account. However, you can only pay extra premiums up to a certain amount of money.

Once you’ve paid premiums above the amount needed to pay up the policy in seven years, the policy changes to a Modified Endowment Contract (MEC). MECs don’t receive the favorable tax benefits of cash value life insurance. Funds from the cash value of an MEC are taken out of interest and investment earnings first, meaning you’ll pay taxes on distributions.

If you’re younger than 59½, you’ll also have a 10% penalty on withdrawals. If your life insurance policy is at risk of becoming an MEC (or already converted to an MEC), we recommend you speak with a financial advisor or insurance agent before making a withdrawal.

What to Do With Insurance Proceeds

  • Cover final expenses: Depending on the final wishes of your loved one, you could face thousands of dollars in expenses to lay them to rest. You can use the money they left you in life insurance proceeds to cover their funeral, burial and other final expenses.
  • Pay off debt: Whether you have a lot of credit card debt, student loans or a mortgage to cover, using life insurance proceeds to pay off debt is often a good choice. Depending on the amount of your payout, consider focusing on debts with high interest rates first.
  • Cover costs of living: Many people get life insurance to cover the cost of living for loved ones, especially if they leave behind a spouse of dependent children.
  • Plan for your children’s future: If you have children, a life insurance death benefit is a great way to establish a college fund for their future education needs.
  • Plan for your future: You can also use life insurance proceeds to help plan for your retirement, pay for your education or purchase a home with a sizable down payment.

The Bottom Line

Cash value life insurance offers significant benefits to protect your loved ones while enjoying a living benefit. While your beneficiaries generally won’t get access to your cash value after you pass away, they can receive the life insurance proceeds from the policy tax-free in a lump sum payout.

You’ll also enjoy tax-deferred benefits on your cash value life insurance policy in most cases. Policyholders who want to avoid paying taxes on cash value can limit how much money they take from their cash value account. You typically won’t have to pay taxes on cash value distributions within the amount of money you’ve paid into the account through premiums.

Frequently Asked Questions About Cash Value Life Insurance Taxes

The money in your life insurance cash value account grows tax-deferred. This means the IRS won’t charge you taxes on your interest or investment income until you withdraw the money in certain circ*mstances. For example, you have $5,000 of cash value and want to withdraw it. You paid $4,000 of the cash value amount through regular premium payments and made the remaining $1,000 through investment gains. The IRS can tax the $1,000 of investment earnings from the account.

Policyholders who owe taxes on interest or investment income in cash value accounts pay their income tax rate on what they owe.

In most cases, cash value life insurance isn’t taxable. Your beneficiaries can receive the death benefit as a lump sum tax-free, though they won’t receive your cash value balance. As a policyholder, you’ll typically only pay taxes on the cash value if you take out more money than you put in through premiums. This happens most often if you take out cash value earned through interest or investments.

Inheritance tax and estate taxes can vary greatly from state to state, which plays a key role in how much tax you owe after the death of a spouse. If you’re the beneficiary of a cash value life insurance policy of your spouse, your life insurance proceeds are tax-free as a lump sum payment.

Methodology: Our System for Ranking the Best Life Insurance Companies

Our goal at the MarketWatch Guides Team is to provide you with comprehensive, unbiased recommendations you can trust. To rate and rank life insurance companies, we created a thorough methodology and analyzed each company by combing through online policy information, speaking to agents via phone, reading customer reviews for insight into the typical customer experience, and reviewing third-party financial reliability scores.

After collecting this data, we scored each company in the following categories: coverage, riders, availability and ease of use and brand trust. To learn more, read our full life insurance methodology for reviewing and scoring providers.

Is Cash Value Life Insurance Taxable? | 2024 Guide (4)

Tara SeboldtContributing Writer

Tara Seboldt is a writer specializing in insurance and personal finance. Prior to writing full-time, Tara spent several years in the financial advisory and life insurance industry. She uses her professional background to help readers better understand complicated (and sometimes boring) topics. When she’s not writing, you’ll find Tara hiking with her dog, riding her horse or planning her next ski trip.

Is Cash Value Life Insurance Taxable? | 2024 Guide (2024)

FAQs

Is Cash Value Life Insurance Taxable? | 2024 Guide? ›

In most cases, cash value life insurance isn't taxable. Your beneficiaries can receive the death benefit as a lump sum tax-free, though they won't receive your cash value balance. As a policyholder, you'll typically only pay taxes on the cash value if you take out more money than you put in through premiums.

How is cash value life insurance taxed? ›

Fortunately, the cash value of life insurance grows tax-free. This means that, in many cases, you won't have to worry about paying taxes on it.

Do I have to report life insurance on my taxes? ›

Generally, life insurance proceeds you receive as a beneficiary due to the death of the insured person, aren't includable in gross income and you don't have to report them. However, any interest you receive is taxable and you should report it as interest received.

Do you get a 1099 for life insurance proceeds if you? ›

Do you get a 1099 for life insurance proceeds? You won't receive a 1099 for life insurance proceeds because the IRS doesn't typically consider the death benefit to count as income.

What is the disadvantage of life insurance with cash value? ›

Some policies take a long time to build up any significant cash value. You could wait many years before you have a substantial amount to access. Cash value is not paid to beneficiaries in most cases. When you pass away, cash value typically reverts back to the life insurance company.

How do I avoid taxes on cash value of life insurance? ›

Life insurance is generally exempt from taxes when your beneficiaries are paid the death benefit; your cash value increases; you borrow money from your cash value; you withdraw cash value, but it's less than what you paid in premiums; or you exchange your life insurance for a different policy or an annuity.

How to avoid taxes with life insurance? ›

Whole life insurance can avoid taxes by building cash value. Your cash value savings grow tax-deferred, so you don't owe income tax as long as you leave the money in your account. In comparison, if you saved through a savings account or a bank Certificate of Deposit, you'd owe tax on your interest each year.

Why did I get a 1099 from my life insurance? ›

If you own a life insurance policy, the 1099-R could be the result of a taxable event, such as a full surrender, partial withdrawal, loan or dividend transaction. If you own an annuity, the 1099-R could be the result of a full surrender, a partial withdrawal or the transfer of the contract to a new owner.

Does life insurance get reported on w2? ›

Employers must report the income from the employee life insurance coverage in a few boxes on a W-2 form. All employers must first determine whether or not their business provides more than $50,000 of group-term life insurance coverage.

Why did I receive a 1099-INT on my life insurance policy? ›

Your policy may have accumulated a dividend. If you chose to have your dividends remain in an interest earning account with the company, the interest is reported on Form 1099-INT when (1) it is $10.00 or greater and/ or (2) federal withholding was required.

Do you have to pay taxes on money you receive as a beneficiary? ›

Generally, beneficiaries do not pay income tax on money or property that they inherit, but there are exceptions for retirement accounts, life insurance proceeds, and savings bond interest. Money inherited from a 401(k), 403(b), or IRA is taxable if that money was tax deductible when it was contributed.

Do you pay capital gains on life insurance? ›

Is life insurance taxable? Life insurance proceeds are usually not taxable as income. However, you may be subject to capital gains or income taxes if you cancel your policy and withdraw the cash value, or sell your policy in a life insurance settlement.

What are the tax advantages of life insurance? ›

Tax-advantaged growth

The cash value of your whole life insurance policy will not be taxed while it's growing. This is known as “tax deferred,” and it means that your money grows faster because it's not being reduced by taxes each year. This means the interest you make on your cash value is applied to a higher amount.

What happens to the cash value after the policy is fully paid up? ›

What happens to the cash value after the policy is fully paid up? The company plans to use the cash value to pay premiums until you die. If you take cash value out, there may not be enough to pay premiums.

Why is cash value life insurance not a good investment? ›

It's also worth noting that cash value will not build up quickly. It may take 10 years or longer before your policy is worth enough for you to reap the benefits. Additionally, the cash value of some policies will revert to the insurance company upon your death.

Should I withdraw cash value from life insurance? ›

"Since a withdrawal generally reduces the policy's death benefit, a person who wants to maximize that payment should not withdraw cash value." Ultimately, deciding whether to draw cash from a life insurance policy comes down to personal need.

Can the IRS take my life insurance cash value? ›

The IRS typically cannot take life insurance proceeds simply because the policy was a cash-value policy. However, if the policy was surrendered for cash during the policyholder's lifetime, any proceeds above the amount of premiums paid into the policy are subject to income tax.

Where do I report cash surrender value of life insurance? ›

Surrender of policy for cash.

Report these amounts on lines 5a and 5b of Form 1040 or 1040-SR.

What is the cash value of a $100,000 life insurance policy? ›

However, most people receive around 20% of the face value on average, according to LISA. So, if we're using that 20% average to calculate the cash value of a $100,000 life insurance policy, the cash value of the policy would be $20,000.

How do you record cash value of life insurance? ›

The cash surrender value of a life insurance policy provides a future economic benefit as it is the amount that can be realized by the company if the policy is surrendered. Therefore, it is the cash surrender value of the life insurance contract that is recorded as an asset on the corporate balance sheet.

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