When clients ask me about the tax implications of life insurance cash value, I can see the concern in their eyes. They’ve worked hard to build wealth, and the last thing they want is an unexpected tax bill down the road. The good news? Cash value from life insurance has some of the most favorable tax treatment available—but there are important details you need to understand.
For a complete overview, see our comprehensive MPI guide.
How Cash Value Growth Is Taxed
The cash value in your life insurance policy grows tax-deferred, which means you don’t pay taxes on the growth while it’s accumulating inside the policy. This is similar to a 401(k) or IRA in that regard—except there are no contribution limits and no required minimum distributions.
Think of your cash value like a bucket that’s filling up over time. As long as the water stays in the bucket, you don’t owe taxes on it. It’s only when you take it out that tax implications come into play—and even then, there are strategies to minimize or eliminate taxes entirely.
Accessing Your Cash Value: Withdrawals vs. Loans
Here’s where it gets interesting. There are two main ways to access your cash value, and they’re taxed very differently.
Cash Value Withdrawals
When you make a withdrawal from your policy, you’re taking money directly out of your cash value. The IRS uses a “first in, first out” (FIFO) method for taxation:
- Your basis (premiums paid) comes out first—this is tax-free because you already paid taxes on this money before putting it into the policy
- Any growth above your basis is taxable as ordinary income
For example, if you’ve paid $50,000 in premiums and your cash value is now $75,000, you could withdraw up to $50,000 tax-free. Anything above that would be taxable.
Policy Loans: The Game-Changer
This is where life insurance really shines from a tax perspective. When you take a policy loan against your cash value, it’s generally not treated as taxable income by the IRS. You’re essentially borrowing against your own money, using the cash value as collateral.
Here’s the beautiful part: when you take a policy loan, you’re not actually removing water from the bucket—you’re just putting a lien against it. The full cash value amount typically continues to earn interest or index credits, while you have use of the borrowed funds.
The MPI Strategy and Tax-Free Income
In my practice, I work with clients who use what’s called the MPI (Maximum Premium Indexing) strategy. This approach involves max-funding an Indexed Universal Life policy and then using the participating loan feature for retirement income.
The strategy works like this: instead of taking withdrawals in retirement (which would eventually become taxable), you take policy loans. Since loans aren’t considered taxable income when structured properly, this can provide a stream of tax-free retirement income.
I had a client couple in their 50s who were contributing the maximum to their 401(k)s but realized they’d face a significant tax burden in retirement. We designed an IUL policy using the MPI strategy that could potentially provide them with tax-free income through policy loans—something their traditional retirement accounts could never offer.
When Cash Value Becomes Taxable
There are situations where cash value can become taxable, and it’s important to understand these scenarios:
Modified Endowment Contracts (MECs)
If you put too much money into a life insurance policy too quickly, it can become what’s called a Modified Endowment Contract. When this happens, any withdrawals or loans are taxed on a “last in, first out” basis, meaning gains come out first and are immediately taxable.
This is why proper policy design is crucial. Working with an experienced agent who understands these limits is essential to maintaining the tax advantages.
Policy Lapses with Outstanding Loans
If your policy lapses (terminates) while you have outstanding loans, those loans can become taxable income. This is probably the biggest tax trap in life insurance, which is why maintaining your policy is critical.
Let’s say you’ve borrowed $100,000 from your policy over the years, and then the policy lapses. The IRS would treat that $100,000 as taxable income in the year the policy lapses—potentially creating a significant tax bill.
Tax-Free Death Benefits
One of the most powerful tax advantages of life insurance is that the death benefit passes to your beneficiaries income tax-free under Section 101(a) of the Internal Revenue Code. This has been the law for over 100 years and provides incredible estate planning advantages.
Even if you’ve taken loans against the policy, your beneficiaries receive the net death benefit (death benefit minus outstanding loans) tax-free.
Estate Tax Considerations
While life insurance death benefits are income tax-free, they may still be subject to estate taxes if you own the policy when you die. For larger estates, this might mean setting up an Irrevocable Life Insurance Trust (ILIT) to remove the death benefit from your taxable estate.
Most of my clients don’t have estates large enough for this to matter, but it’s worth discussing with your tax advisor if you’re dealing with significant wealth.
The Power of Tax Diversification
What I love about properly designed life insurance is that it gives you tax diversification in retirement. Most people have their money in tax-deferred accounts (401(k), traditional IRA) or taxable accounts. Life insurance gives you a third bucket: tax-free access through policy loans.
This diversification can be incredibly powerful. In retirement, you might take some income from your 401(k) (taxable), some from a Roth IRA (tax-free), and some from life insurance loans (tax-free). This gives you flexibility to manage your tax bracket year by year.
Working with Tax Professionals
I always recommend that my clients work with qualified tax professionals when implementing these strategies. While I can explain how the tax benefits generally work, your specific situation might have unique considerations that require professional tax advice.
The key is making sure everyone on your team—your insurance agent, tax preparer, and financial advisor—understands what you’re trying to accomplish so they can work together effectively.
State Tax Considerations
Don’t forget about state taxes. While life insurance death benefits are generally income tax-free at both federal and state levels, some states have inheritance taxes that might apply. Policy loans are typically not subject to state income tax either, but rules vary by state.
- Understand that life insurance cash value grows tax-deferred with no contribution limits or required minimum distributions, unlike traditional retirement accounts.
- Choose policy loans over withdrawals to access your cash value since loans are generally tax-free while withdrawals become taxable once they exceed your premium payments.
- Leverage the fact that policy loans don’t reduce your cash value balance, allowing your full amount to continue earning growth while you use the borrowed funds.
- Consider the MPI (Maximum Premium Indexing) strategy to create tax-free retirement income streams by taking policy loans instead of taxable distributions from traditional accounts.
- Avoid putting too much money into your policy too quickly, as this can create a Modified Endowment Contract (MEC) that eliminates the tax advantages of policy loans.
The Bottom Line
Is cash value from life insurance taxable? The answer is: it depends on how you access it. Growth within the policy is tax-deferred, withdrawals up to your basis are tax-free, loans are generally not taxable income, and death benefits are income tax-free.
The key is proper planning and policy design. When done correctly, life insurance can provide some of the most tax-advantaged wealth accumulation and distribution available.
Related Reading
- Retirement Income Solutions: What You Should Know
- MPI Investment: What You Should Know
- LIRP Life Insurance: What You Should Know
- Policy Loan Life Insurance: What You Should Know
Ready to explore your options? As an independent agent, I work with multiple top-rated carriers and can help you understand how life insurance might fit into your overall financial and tax strategy. Let’s have a conversation about your specific situation and goals.
Get your personalized analysis today. I’ll review your current planning and help you determine if the tax advantages of properly designed life insurance make sense for your situation.
