Cashing in a life insurance policy becomes taxable when the cash received exceeds your cost basis (total premiums paid minus dividends/refunds), with the gain taxed as ordinary income, potentially facing a 10% penalty if under 59½; withdrawals up to your basis are tax-free, but loans taken against the policy can become taxable if the policy lapses before repayment, creating a tax liability for the outstanding balance.
Cashing out your policy
You're able to withdraw up to the amount of the total premiums you've paid into the policy without paying taxes. But if you withdraw on any gains, such as dividends, you can expect them to be taxed as ordinary income.
Your premium is as low as it will ever be. The longer you hang onto it, the higher the value will be if you ever do decide to cash out. You might get a higher return with the money, but it's a higher risk also.
Calculate the Taxable Amount
The taxable amount is the difference between the cash surrender value and the total premiums paid. If the cash surrender value is greater than the total premiums paid, the excess amount is considered taxable income.
3 Ways to Avoid Taxes on Life Insurance Benefits
The 'seven-pay test' simply refers to how the government determines if your life insurance becomes a MEC. This test generally limits how much you as a policyholder can deposit each year during the first seven years of your policy.
In 2025, the first $13,990,000 of an estate is exempt from federal estate taxes, up from $13,610,000 in 2024. Estate taxes are based on the size of the estate. It's a progressive tax, just like the federal income tax system. This means that the larger the estate, the higher the tax rate it is subject to.
There are no tax consequences if the total amount of such policies does not exceed $50,000. The imputed cost of coverage in excess of $50,000 must be included in income, using the IRS Premium Table, and is subject to Social Security and Medicare taxes.
First, add up the total payments you've made toward your life insurance policy. Then, subtract the surrender fees your insurance company will charge. You'll be left with the actual payout you may receive if you terminate or surrender your life insurance.
Costs and drawbacks of cash-value life insurance
Premiums for these policies are far higher than those for term life insurance, and additional features—known as riders—carry their own fees. Commissions are another significant cost that adds to the overall expense of these policies.
Dave recommends a policy amount of 10-12 times your annual income with a 15- to 20-year term, or up to 30 years for younger families.
Berkshire Hathaway owns companies like GEICO and General Re, and it invests heavily in life insurance operations. Insurance is not just a side business for Buffett. It is the foundation of his success. Buffett understands that insurance is about managing risk fairly and building trust.
Whole life insurance builds cash value, but here's the catch: It can take years—sometimes over a decade—before the cash value grows into a meaningful amount. Initially, most of your premiums are allocated to fees, commissions, and insurance costs.
Any other arrangement can fall into the transfer-for-value trap. If a policy is transferred for money or something of value, the death benefit is no longer fully income tax free. For example, the mutual obligation to purchase a co-owner's business interest at his death would be considered something of value.
Surrender of policy for cash.
You should receive a Form 1099-R showing the total proceeds and the taxable part. Report these amounts on lines 5a and 5b of Form 1040 or 1040-SR.
Is there a penalty for cashing out whole life insurance? There is typically no penalty for cashing out whole life insurance because these policies are designed to offer the opportunity to help build wealth. However, surrendering the policy may result in surrender charges if done before a specified date.
It depends. The difference is considered taxable income if the total cash value you receive exceeds the amount you've paid in premiums. If your payout is less than or equal to your cost basis (the total amount you've paid in premiums), there are no taxes owed.
You may not be able to afford your premiums, or you might need a sum of money quickly. But price isn't the only reason you might surrender a life insurance policy. Maybe you don't need coverage anymore, you've outlived your beneficiaries or you need your money more than your beneficiaries.
The exact timing depends on your insurance provider's processing time. Surrendering a Policy: Surrendering your policy usually takes longer, often around two to six weeks, because the insurance company will need to process your request and determine the cash surrender value after deducting fees.
For the wealthy, life insurance is an unsexy yet powerful tactic for avoiding taxes. By putting the policy inside a trust, the death benefit is excluded from estate taxes. The payout goes to the trust, which pays Uncle Sam and protects the remaining assets from lawsuits.
Drawbacks of term life insurance
If you outlive the term of your term life insurance, the policy expires and has no value. If you're looking for a way to leave money behind, a term life insurance policy most likely isn't a good fit. No cash value. Term life insurance doesn't build cash value.
Ways to avoid paying taxes on life insurance policies
You don't have to report gifts to the IRS unless the amount exceeds $19,000 in 2025. Any gifts exceeding $19,000 in a year must be reported and contribute to your lifetime exclusion amount. You can gift up to $13.99 million over your lifetime without paying a gift tax on it (as of 2025).
How does the IRS find out about inheritance from parents? The estate itself is required to report asset transfers via various tax forms (like Form 706 for estate tax or Form 1041 for estate income). These forms alert the IRS to the assets.
IHT may have to be paid on the estate if it's worth more than the tax-free threshold of £325,000. This means that the first £325,000 of your estate is tax-free – the 40% tax only applies to any assets over this threshold.