When Life Insurance Is Taxable: Six Exceptions to the Rule

Written and reviewed by Hans Goldstein, licensed insurance producer, NPN 20602398 · CA Insurance License #4273294
Last reviewed October 3, 2026 · Published October 3, 2026

1. Transfer for value

If a policy is transferred for valuable consideration, the income tax exclusion is generally limited to what the buyer paid plus later premiums; the rest is taxable. Exceptions include transfers to the insured, a partner of the insured, a partnership with the insured, or a corporation where the insured is a shareholder or officer (IRC 101(a)(2)). Since 2018, those exceptions do not apply to a "reportable policy sale" such as a life settlement, under IRC 101(a)(3).

2. Employer-owned life insurance

When a business owns a policy on an employee, the exclusion can be capped at premiums paid unless the notice-and-consent requirements were met before issue and an exception applies (for example, the insured was an employee within 12 months of death, or was a director or highly compensated). The business also files Form 8925 (IRC 101(j)). Key person and buy-sell policies are the usual cases.

3. Interest on proceeds

If the death benefit is left with the insurer and earns interest, the interest is taxable; if it is paid in installments, only the prorated principal is excluded (IRC 101(c) and (d)).

4. Estate tax

Income tax and estate tax are separate. Proceeds are included in the insured's gross estate if payable to the estate or if the insured held any incident of ownership (IRC 2042). With a $15,000,000 per-person exemption in 2026 most estates owe no federal estate tax, but large estates and residents of states with their own estate tax can. Life insurance and estate tax.

5. Gains on surrender or lapse

Cash surrender value above basis is ordinary income, and a lapse with a loan can create taxable income with no cash (lapse with a loan).

6. MEC distributions

Loans and withdrawals from a modified endowment contract are taxed gain first, plus a 10% additional tax before 59½ (MEC rules).

One more trap: three different people

When the owner, the insured and the beneficiary are three different people (for example, a wife owns a policy on her husband with the children as beneficiaries), the death benefit paid to the children can be treated as a gift from the owner. Structure ownership with your estate attorney.

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Hans Goldstein · 213-414-2808 · NPN 20602398, independent licensed insurance producer

Frequently asked questions

Sources

1. 26 U.S.C. §101 (death benefits, accelerated benefits), Cornell LII
2. If a policy is transferred for valuable consideration, the exclusion is limited to the consideration paid plus later premiums; exceptions: carryover-basis transfers and transfers to the insured, a partner of the insured, a partnership in which the insured is a partner, or a corporation in which the insured is a shareholder or officer (as of 2026)
3. IRC 101(a)(3), added by TCJA (Pub. L. 115-97 sec. 13522, Dec. 22, 2017; transfers after Dec. 31, 2017), says the transfer-for-value exceptions in the second sentence of 101(a)(2) do NOT apply to a reportable policy sale (acquirer with no substantial family, business or financial relationship with the insured) (as of 2017-12-22)
4. Employer-owned life insurance: the employer's exclusion is capped at premiums paid unless an exception applies (insured was an employee within 12 months of death, a director or highly compensated at issue, or proceeds go to heirs or buy equity) AND written notice and consent were obtained before issuance (insured told of intent to insure and max face, consents in writing incl. post-employment coverage, told employer is beneficiary). Annual reporting on Form 8925 (as of 2026)
5. Interest paid on proceeds left with the insurer is taxable (101(c)); when proceeds are paid in installments, only the prorated principal is excluded and the interest element is taxable (101(d)) (as of 2026)
6. Life insurance proceeds are included in the gross estate if receivable by the executor or if the decedent held incidents of ownership; this is estate tax, separate from the 101(a) income-tax exclusion (as of 2026)