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

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.

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.

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.

• 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.

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.

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.