When you buy life insurance, remember that the cash value and insurance payouts come with specific tax rules.
Life insurance premiums are not usually tax-deductible. You may, however, be able to deduct them as a business expense if you are not directly or indirectly a beneficiary of the policy.
Life insurance proceeds are usually not taxable Generally, the 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. If the policy was transferred to you for cash or other valuable consideration, the amount you can exclude from taxes is limited to the sum of the consideration you paid, any additional premiums you paid, and certain other amounts.
However, life insurance proceeds can become taxable if they are included in your estate and your estate exceeds the $15 million filing threshold (the per-person exemption set by OBBBA for 2026, indexed thereafter). 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) When your employer includes life insurance as part of your compensation package, the IRS treats it as taxable income. However, you are only taxed on the coverage exceeding $50,000. The cost of the first $50,000 in coverage is not subject to taxes.
For example, if your employer provides a life insurance policy worth $100,000, you will need to pay taxes on the portion of the coverage that exceeds $50,000. The taxable amount is determined by IRS tables in Publication 15-B, which apply regardless of the actual premium paid. For example, a 70-year-old with $50,000 in coverage beyond the exempt amount would have an additional taxable income of per month, or $1,236 annually.
Cash Value Plans: Tax-free Death Benefit and Tax-deferred Growth Before IRC Section 7702 was introduced, the federal tax law was quite lenient on the taxation of life insurance policies. The government aimed to avoid taxing the death benefits received by life insurance beneficiaries, such as widows and children, making these benefits exempt from income tax. Additionally, any gains accumulated within the policy during the policyholder’s lifetime weren’t taxed as income.
However, this favorable tax treatment had its drawbacks, especially when it allowed for the manipulation of the system, with some investment accounts being disguised as life insurance products.
To tackle this issue, starting 2021, Section 7702 established specific criteria to ensure that only legitimate life insurance policies benefited from this favorable tax treatment, rather than investment schemes pretending to be life insurance.
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.