When I work with clients, one of the most common questions I get is about the tax implications of cash value in their life insurance policies. It’s a great question—and one that can have significant implications for your financial planning.
For a complete overview, see learn more about the MPI strategy.
The simple answer is: cash value growth in life insurance is generally not taxable while it remains in the policy. But like most things in the tax code, there are important details and exceptions you need to understand.
How Cash Value Growth Works
Let me start with the basics. Cash value life insurance policies—like whole life, universal life, and indexed universal life—have two components: the death benefit and the cash value account. As you pay premiums, a portion goes toward insurance costs and a portion builds cash value.
This cash value grows over time through interest crediting (in universal life policies) or dividends (in whole life policies). The key tax advantage is that this growth is tax-deferred—meaning you don’t pay taxes on it while it’s accumulating inside the policy.
Think of it like a 401(k) or traditional IRA in this respect. The money grows without annual tax consequences, which allows for more efficient compounding over time.
When Cash Value Becomes Taxable
While the growth itself isn’t taxable, accessing that cash value can create tax consequences depending on how you do it. Here are the main scenarios:
Policy Surrenders (Canceling the Policy)
If you surrender your policy completely, you’ll receive the cash value minus any outstanding loans. The taxable portion is calculated using what’s called the “FIFO” method—first in, first out.
Here’s how it works:
- Total premiums paid: $50,000
- Cash value received: $75,000
- Taxable gain: $25,000
You’d owe ordinary income tax on that $25,000 gain. This is where many people get surprised—they didn’t realize they’d created a taxable event.
Partial Withdrawals
Many policies allow you to make partial withdrawals from your cash value. These are also treated under the FIFO method, but with an important distinction: withdrawals up to your total premium payments (your “basis”) are generally not taxable.
Using the same example above, if you withdrew $30,000 from a policy where you’d paid $50,000 in premiums, that withdrawal would typically be tax-free because you’re essentially getting back money you already paid taxes on.
Policy Loans - The Tax-Advantaged Option
This is where cash value life insurance really shines from a tax perspective. Policy loans are generally not treated as taxable income, even when the loan amount exceeds your premium payments.
When you take a policy loan, you’re not technically withdrawing money from the policy. Instead, the insurance company is lending you money and using your cash value as collateral. Your cash value remains in the policy and continues to earn interest or dividends.
I often use this analogy with clients: think of your cash value like a savings account at a bank. When you take a loan against that account, you’re not withdrawing your savings—you’re borrowing money using your savings as security. The bank (or insurance company) can’t tax you on borrowed money.
The MPI Strategy and Tax Advantages
In my practice, I often discuss how properly structured life insurance can be used as part of a comprehensive retirement strategy. The MPI (Maximum Premium Indexing) strategy takes advantage of these tax benefits by using a max-funded indexed universal life policy.
Here’s why the tax treatment matters so much: in retirement, instead of taking taxable distributions like you would from a 401(k) or traditional IRA, you can access your cash value through policy loans. These loans are generally not treated as taxable income, which can provide significant tax advantages.
Consider this comparison: if you have $1 million in a traditional 401(k) and follow the 4% withdrawal rule, you’d have $40,000 in annual income. After federal and state taxes, you might net around $32,000-$36,000.
With a properly designed life insurance policy using the MPI strategy, you could potentially access up to 10% annually through policy loans—$100,000 from that same $1 million—and it could be tax-free through the loan feature.
Modified Endowment Contracts (MECs)
There’s an important exception I need to mention: Modified Endowment Contracts, or MECs. These are life insurance policies that have been overfunded beyond IRS limits.
If your policy becomes a MEC, the tax treatment changes significantly:
- Loans and withdrawals are taxed on a “last in, first out” basis
- You pay taxes on gains first, rather than getting back your basis first
- There may be additional 10% penalties if you’re under age 59½
This is why proper policy design is so critical. When I work with clients on cash value strategies, we carefully structure the policy to avoid MEC status while still maximizing the cash value accumulation.
Estate Tax Considerations
While we’re talking about taxes, it’s worth mentioning estate taxes. Life insurance death benefits are generally income tax-free to beneficiaries under IRC Section 101(a). However, if you own the policy, the death benefit could be included in your estate for estate tax purposes.
For most families, this isn’t a concern because the federal estate tax exemption is quite high (over $12 million per person as of 2024). But for high-net-worth individuals, there are strategies like irrevocable life insurance trusts (ILITs) that can remove the policy from the taxable estate.
Important Considerations and Limitations
Before you get too excited about the tax advantages, let me share some important caveats:
Policy Performance Matters
The tax advantages only work if the policy stays in force. If a policy lapses with outstanding loans, you could face a significant taxable event. The outstanding loan balance could become taxable income in the year of lapse.
Interest on Loans
While policy loans aren’t taxable, you do pay interest on borrowed amounts. Current rates are typically around 4-6%. The key is ensuring your cash value growth exceeds the loan interest rate over time.
Long-Term Commitment Required
These strategies work best as long-term approaches. Early surrender charges and the time needed for cash value to accumulate mean this isn’t a short-term solution.
Working with a Professional
Given the complexity of insurance taxation and the importance of proper policy design, I always recommend working with a licensed insurance professional who understands these strategies.
In my experience, many financial advisors focus primarily on investment accounts and may not fully understand the tax advantages of properly structured life insurance. That’s not a criticism—it’s just outside their primary area of expertise.
Making the Right Decision for Your Situation
The question isn’t whether insurance cash value is taxable—it’s whether a cash value strategy makes sense for your specific situation. Factors to consider include:
- Your current tax bracket vs. expected retirement tax bracket
- Other retirement savings you have
- Your time horizon
- Your risk tolerance
- Your estate planning goals
For some families, maximizing 401(k) contributions and using term life insurance makes the most sense. For others, incorporating a properly designed cash value policy as part of their overall strategy can provide valuable tax advantages and retirement income flexibility.
- Understand that cash value growth inside your life insurance policy remains tax-deferred, similar to a 401(k), allowing your money to compound more efficiently over time.
- Consider policy loans instead of withdrawals when accessing cash value, as loans are generally not treated as taxable income even when they exceed your premium payments.
- Know that surrendering your policy completely creates a taxable event where you’ll owe ordinary income tax on any gains above the premiums you’ve paid.
- Recognize that partial withdrawals follow the FIFO method, meaning withdrawals up to your total premium payments are typically tax-free since you’re getting back money you already paid taxes on.
- Plan your cash value access strategy carefully since the method you choose to access your money makes all the difference in your tax consequences.
The Bottom Line
To answer the original question directly: cash value growth in life insurance is generally not taxable while it remains in the policy, and it can often be accessed tax-free through policy loans when properly structured.
But the real value isn’t just in understanding the tax rules—it’s in determining whether this strategy fits into your overall financial plan. The tax advantages can be significant, but they need to be weighed against costs, time commitments, and your other financial priorities.
Every family’s situation is different, which is why I don’t believe in one-size-fits-all solutions. As an independent agent, I take the time to understand your specific needs and can show you how different strategies might work for your situation.
Related Reading
- Benefits of IUL: What You Should Know
- Indexed Universal Life Insurance Pros and Cons
- MPI Investment: What You Should Know
- Retirement Income Solutions: What You Should Know
Ready to explore your options? Schedule a free consultation and let’s discuss whether a cash value strategy makes sense for your financial goals. I’ll walk you through the numbers and help you make an informed decision that’s right for your family.
