Taxation of Life Insurance
When you buy life insurance, remember that the cash value and insurance payouts come with specific tax rules.
Life insurance premiums are not deductible. IRC §264, “Certain amounts paid in connection with insurance contracts” disallows the deduction for any policy where the taxpayer is directly or indirectly a beneficiary — which covers essentially every policy you would buy on yourself or your spouse. The narrow business exception is for policies where the employer has no beneficial interest, and even there IRC §101, “Certain death benefits” (specifically IRC §101(j)) makes the death benefit on employer-owned coverage taxable unless the notice-and-consent and reporting requirements were satisfied before the policy was issued. If a business owns life insurance on a key employee, verify that the pre-issuance consent file exists; it cannot be created retroactively.
Life insurance proceeds are usually not taxable Under IRC §101(a)(1), life insurance proceeds you receive as a beneficiary due to the death of the insured person are not included in your gross income, and you do not need to report them. However, any interest you receive is taxable, and you should report it as interest income. For more information about interest, see IRS Topic 403. The transfer-for-value rule in IRC §101(a)(2) is the trap: if the policy was transferred to you for cash or other valuable consideration, the exclusion collapses to the consideration you paid plus subsequent premiums, and everything above that is ordinary income. The statutory exceptions — transfer to the insured, to a partner of the insured, to a partnership in which the insured is a partner, or to a corporation in which the insured is an officer or shareholder — are why buy-sell agreements are drafted as cross-purchase-through-a-partnership instead of a casual policy swap between shareholders.
Keep two taxes separate here, because the distinction decides the planning. Death benefits are never subject to income tax in the beneficiary’s hands. They can absolutely be subject to estate tax: under IRC §2042 the proceeds are pulled into the insured’s gross estate if the insured held any incident of ownership at death — the right to change the beneficiary, borrow against the policy, surrender it, or assign it — or if the proceeds are payable to the estate. Once in the gross estate they are taxed with everything else above the $15 million per-person exemption (OBBBA level for 2026, indexed thereafter). This is the entire reason the ILIT exists (section “Second-to-die Policy”, section “Life Insurance Workaround”): the trust, not you, owns the policy, so there is no incident of ownership to attribute. Note the companion trap in IRC §2035, “Transfers within 3 years of death”: transferring an existing policy into an ILIT pulls the full death benefit back into the estate if the insured dies within three years of the transfer. A policy issued to the trust from inception has no such exposure — which is why the trust should be created and funded first, and the application signed by the trustee. See instructions to Schedule D—Insurance on the Decedent’s Life.
No Sales Tax On Buying Unlike purchasing a car or a computer, buying life insurance does not involve paying sales tax. This means the premium amount quoted to you as the policyholder is the total amount you pay, without any additional percentage for taxes.
However, states usually impose a tax on the premiums collected, which varies by state and is likely passed on to the consumer. For instance, Alabama imposes a premium tax on life insurance premiums that ranges from 0.5% to 2.3%.
Employer-Paid Life Insurance (Group-Term Life Insurance Coverage) IRC §79, “Group-term life insurance purchased for employees” excludes the cost of the first $50,000 of employer-provided group-term coverage from your income. Coverage above $50,000 generates imputed income — and, importantly, the amount imputed is not what the employer actually paid. It is a flat per-$1,000 rate from the Uniform Premium Table I in Treas. Reg. §1.79-3(d)(2), which is why group life is a bargain for a healthy 35-year-old and a quiet tax on a 70-year-old.
The computation, from IRS Publication 15-B:
where is total coverage and is the Table I rate per $1,000 per month. For a 70-year-old () with $100,000 of coverage:
Run the same arithmetic at 35 () and the imputed income is $4.50 a month. If your employer offers supplemental group life at older ages, price it against individual term before electing it — past roughly age 60 the Table I imputation alone frequently exceeds what a healthy insured would pay for a standalone policy.
Cash Value Plans: Tax-free Death Benefit and Tax-deferred Growth Before IRC Section 7702 was enacted, federal tax law was lenient about what could call itself life insurance. The policy goal was defensible — keep death benefits to widows and children out of income tax, and leave the inside build-up untaxed while the policy is in force — but with no definition of “life insurance” in the Code, the treatment was available to investment accounts wearing a thin mortality wrapper.
Congress closed that in 1984, in the Deficit Reduction Act, by enacting IRC §7702 with the CVAT and GPT limits described above; the seven-pay test of IRC §7702A followed in 1988 to stop the single-premium workaround. The change people mean when they say “7702 changed in 2021” is narrower and works in the buyer’s favor: §205 of Division EE of the Consolidated Appropriations Act, 2021 replaced the fixed 4% and 6% statutory interest assumptions — written when rates were high and left frozen for 37 years — with a floating rate tied to prescribed benchmarks, initially 2%. Because the assumed rate sits in the denominator of the premium limits, lowering it raises how much premium a given death benefit can absorb, which is what made modern overfunded designs and institutional PPLI structures workable at current rates. Bobby Samuelson’s write-up of the change walks through the mechanics.
By adhering to these guidelines, permanent life insurance policies offer a double advantage: they provide a tax-free death benefit and feature a cash value account that grows tax-deferred, as long as the policy remains active. This means you won’t owe taxes on the growth of your policy’s cash value until you make a withdrawal, allowing for the potential accumulation of more savings over time. This feature can be particularly advantageous for those in a higher tax bracket during their working years who anticipate being in a lower tax bracket during retirement, at which point withdrawals are made.
These policies also allow you to access the cash value on a tax-advantaged basis, similar to a Roth IRA. Withdrawals or loans taken against the policy’s cash value are not taxed up to the amount of premiums you’ve paid, known as the “cost basis”. This offers significant flexibility, enabling you to use these funds for various needs, including supplementing retirement income, covering unexpected medical expenses, or funding education. However, accessing the cash value through loans or withdrawals can affect the policy’s death benefit and may require additional premium payments to maintain the intended benefits of the policy.