Tax Myths and Realities of Life Insurance: What the IRS Really Allows

Life insurance payouts are generally tax-free, but exceptions exist. If you misunderstand the tax rules, the IRS will knock on your door, with bills in hand. Most of the exceptions come with accessing the living benefits that come with permanent life insurance.

In this guide, we will debunk common tax myths surrounding life insurance and explain the actual tax treatment of cash value, withdrawals, loans, and death benefits.

Myth #1: “All Life Insurance Benefits Are Always Tax-Free”

Reality: Death benefits are generally tax-free for beneficiaries, but ownership and beneficiary designations matter.

It’s important to know the exceptions to avoid a heavy, unexpected tax burden. Let’s go over common exceptions.

Payout goes to the estate

If no beneficiaries are named, or you specify your own estate as the beneficiary, then the proceeds that go to your own estate can be subject to estate tax. This happens if your estate value (including the life insurance proceeds) exceeds the federal estate tax threshold.

The tax threshold for the federal estate tax changes. It was $13.61 million in 2024.

Annuity

If a beneficiary chooses to receive the death benefit as an annuity instead of a lump sum, any interest that accrues over time can be subject to taxes.

Corporate-owned life insurance policy

Corporate-owned life insurance (COLI) policies provide tax benefits and are useful for funding buy-sell agreements. Their cash value grows tax-deferred and their death benefits are generally tax-free. But if your business withdraws from or takes a loan against the life insurance policy, these amounts can be taxed.

In addition, COLI policies are somewhat risky. At the moment, businesses can be the sole beneficiary of a life insurance policy. But with new tax or estate laws, this may change. Some believe that COLI policies are not ethical, and if your business’ tax policies seem to be taking advantage of any tax loopholes, it could be penalized. There is also the concern of Stranger-Originated Life Insurance (STOLI), which could mean extra scrutiny for your COLI.

Myth #2: “Cash Value Growth Is Tax-Free Forever”

Reality: Cash value growth is tax-deferred, not tax-free. Taxes can apply. Here are the most common ways your cash growth can result in taxes.

Lapsed policy

If you lapse your life insurance policy but you have a taxable gain, then it would be taxed as ordinary income. Lapsing a life insurance policy makes it essentially worthless because it means you failed to pay the premiums and not enough cash value exists in the policy to cover the premiums.

Surrendered with gains

If you surrender your life insurance policy and it has gains, it can be taxed. This occurs if you:

• Receive more funds than your cost basis (amount you’ve put into the policy in premiums)
• Have more outstanding policy loans than the cost basis

Modified Endowment Contracts (MECs)

An MEC will trigger immediate taxation and penalties. It basically triggers if you have paid unnecessary premiums too many times in a row. If you trigger the MEC, any withdrawals or loans you make can be taxed. This can be very expensive, so be careful if you want to make multiple premium payments at once.

Myth #3: “Policy Loans Don’t Affect Taxes”

Reality: Loans are generally only tax-free while the policy remains in force (AKA active). If you surrender or lapse your policy, outstanding loans can become taxable income.

When is a life insurance loan taxable?

If you don’t pay off your life insurance loan, but also fail to maintain active coverage (i.e. the coverage lapses), then you could be taxed on the loan. Make sure to monitor your loans to avoid accidental tax bills. It is important to avoid a coverage lapse, especially if you are still paying back a loan against your policy.

Myth #4: “Withdrawals Are Always Tax-Free”

Reality: Withdrawals from your permanent life insurance policy are tax-free up to the amount of premiums paid.

The amount of premiums paid is called the cost basis. Any amount exceeding that will be taxable as ordinary income. So be careful withdrawing too much from your permanent life insurance policy. Withdrawals can be extremely useful for retirement, emergencies, and other expenses, but it’s risky to withdraw too much, especially early on in the life of your policy.

Also note, if you make any partial withdrawals from your life insurance policy, it will reduce your cash value and potentially lower the policy’s death benefit.

Myth #5: “Life Insurance Avoids All Estate Taxes”

Reality: While death benefits usually skip income tax, they may still be subject to estate tax if the insured owns the policy.

How do ILITs help you maintain benefits

An ILIT is an irrevocable life insurance trust. They can help you maintain your benefits by keeping the life insurance outside of your taxable estate. Essentially, after you place your policy into the trust, the trust owns it, not you. The life insurance policy cannot simply be taken out or adjusted.

High-net-worth estate planning

Those with large estates need to thoroughly consider tax implications of their estate planning decisions. A tax professional is necessary to ensure every step of the way is compliant with the law and valuable opportunities are not missed.

IRS Rules to Keep in Mind

MEC rules and the 7-pay test

The Modified Endowment Contract (MEC) rule for life insurance almost acts as a trap within your policy premium. If you pay too much in premiums, it can actually trigger the federal MEC rule, losing your cash value tax benefits. There can be tax implications on any withdrawals and loans you make after that.

MEC rules only trigger if you have a life insurance policy with cash accumulation on top of the regular death benefit. This means something like a universal life or whole life policy.

The 7-pay test is used to see if your premiums paid exceed the IRS limits.

If you’re wondering why the MEC rule exists, it is because in the 20th century, it was possible to invest a significant amount of money into a cheap permanent life insurance policy. This made for an easy tax shelter with high growth rates, especially when cash-value life insurance policies hit an interest rate of 20% in the 1980s.

Tax treatment of dividends

In some life insurance policies, dividends are not considered taxable. Instead, they are treated as a return of premium, which lowers the cost basis. Essentially, dividends are refunds of premiums that you pay.

As long as these dividends do not exceed your cost basis, they shouldn’t be taxed. If they do, then the excess amount would be taxed as ordinary income.

1035 exchanges

In the IRS code, the 1035 exchange for life insurance lets you swap policies tax-free. You can transfer your existing life insurance policy to another kind, which means more control and flexibility over your coverage. It comes with conditions though, such as:

• Ownership must remain the same
• You may still need to pay surrender charges and fees
• Qualified accounts like IRAs and 401(k)s cannot be 1035 exchanged

Make sure the transfer is 1035 exchange compliant and properly done, or it can cause issues later.

3 year lookback rule

The 3-year rule is meant to combat tax avoidance. If you gift your life insurance to an ILIT within three years of your death, it will trigger the 3-year lookback. The life insurance will be included in your estate for tax purposes if the lookback determines it should be.

Practical Tax Planning Tips

Tax advisor

Planning on making a large withdrawal, or taking out a loan against your life insurance policy? It’s best to work with a tax advisor before making the decision. If you have any particular financial goals or complex estate, a tax advisor can provide you with personalized counsel. Although we provide tips and have outlined common myths, everyone’s situation may be different due to individual variances and factors.

Review ownership structure

Life insurance policies can be owned by different entities or individuals, which can have different tax implications. Ownership can also impact asset protection, life insurance modifications, and estate planning outcomes.

Personal ownership: You have full control over the life insurance policy. You can modify it, surrender it, take loans against it, as possible. However, you will need to pay fees and if the death benefit proceeds end up in your estate, it could get taxed.

Trust ownership: If a properly structured irrevocable trust owns the life insurance policy, the death benefit will be excluded from the taxable estate. However, it can trigger the 3-year rule period if you die within 3 years of transferring the life insurance to an irrevocable life insurance trust.

Business ownership: Premiums for a business-owned life insurance policy are usually not tax deductible, and the proceeds may be taxed in certain situations. Proceeds may impact your corporate balance valuation and sheets, which could have tax implications.

Keep policies in force

To avoid unintended taxable events, make sure your policies remain active. Unfortunately, life can get in the way of life insurance. Policies usually have a 30 to 31 day grace period during which you can pay the premium late without penalties and fees.

If you fail to make payments on a term life insurance policy, it will lapse. You could reinstate it, but you would incur extra fees. A lapsed policy means you have no coverage, so if you die, there is no death benefit.

If it’s a permanent life insurance policy with cash growth, then typically the cash value is automatically used to pay the missed premium after the grace period. That way it won’t lapse unless the cash value is completely depleted.

Regularly review policy status

To avoid lapses and tax issues, review your policy status every year or sooner. That way if you unknowingly lapse, you can reactivate it again according to the conditions given by your life insurance company. Insurers are legally required to notify you if you lapse in coverage, but it’s easy to overlook the warnings if you are busy with other life events.

There are conditions to reinstating a life insurance policy though–you are not given indefinite time. You may only get 2 to 5 years to reinstate it, and it may require you to undergo a new medical exam. Premiums could raise, and fees may exist.

Track your cost basis

The cost basis (amount of premiums paid on the life insurance policy) determines whether loans or dividends or other amounts need to be taxed as ordinary income. Because of how important it is, you should track your cost basis with each payment. Update it so you know how much you can borrow, surrender, or withdraw without needing to pay extra taxes.

Conclusion

Life insurance offers unique tax benefits, but misconceptions about how they work can lead to costly surprises. The IRS has rules for cash value growth, excessive premium payments, withdrawals, and large estates.

Consult with a financial advisor and tax professional to maximize benefits while staying compliant with tax laws. If you’re looking for a reliable, high-value life insurance policy, check out these universal life insurance policies.