What You Really Owe the IRS When You Sell Your Life Insurance Policy
You’re considering selling your life insurance policy through a life settlement and want to know if the cash you receive is taxable. The answer is yes—but how much you owe depends on how much you’ve paid into the policy, how much you receive, and how the IRS classifies the transaction.
Part of the Payment Is Tax-Free: Your Basis
Tax-Free Up to: Total Premiums Paid
If you sell your life insurance policy, the amount equal to the premiums you paid into it (your basis) is tax-free. The IRS views this as a return of your investment, not income.
✔ No tax owed on your original investment
✘ Only applies to what you’ve paid in—not any gain
Who Needs It: Anyone trying to understand what portion of the sale is protected from tax
Who Doesn’t: Those who received the policy as a gift (basis rules differ)
Amount Above Basis Up to Cash Surrender Value: Taxed as Ordinary Income
Ordinary Income Tax: Cash Surrender Value minus Premiums Paid
If you sell the policy for more than you’ve paid in but less than the surrender value, that portion is taxed like income. This is similar to how interest earnings are taxed.
✔ Taxed only on the earnings portion
✘ Ordinary income tax rates can be high
Who Needs It: People selling policies still in force with cash value
Who Doesn’t: Those selling term life policies (no surrender value)
Amount Above Cash Surrender Value: Capital Gains Tax
Capital Gains Tax: Settlement Payout minus Cash Surrender Value
If your life settlement payout exceeds your policy’s cash value, the overage is taxed as a capital gain. This generally results in lower taxes than ordinary income.
✔ Capital gains rates are often lower than income tax rates
✘ Still taxable—even if you’re terminally ill (unless viatical exception applies)
Who Needs It: High-income sellers seeking better tax treatment
Who Doesn’t: Policyholders eligible for viatical settlements (those may be fully tax-exempt)
Helpful Add-On: Viatical Settlement Exception
If the insured is terminally or chronically ill and the buyer is licensed, proceeds from a viatical settlement may be completely tax-free.
✔ 100% tax-exempt if conditions are met
✘ Strict definitions of illness and buyer qualifications apply
Also Consider: A permanent life insurance policy with cash value could be borrowed against tax-free or surrendered for income, avoiding settlement taxes altogether.
Annuities as a Tax-Friendly Alternative
Selling a policy often leads to taxation—but 1035 exchanges into annuities can defer taxes while securing guaranteed income.
✔ No immediate tax due on gains
✔ Can provide lifetime income
✘ You give up the death benefit of the original policy
Who Needs It: Policyholders not needing life insurance but wanting a safe income
Who Doesn’t: People who need the policy’s death benefit for family or estate planning
Book a Call With The Annuity Expert
Compare tax-deferred annuity options, get free quotes, and explore whether selling or exchanging your life insurance is the smartest move. No obligation, just real answers.
Book A Free Consultation
Get help from a licensed financial professional. This service is free of charge.
Let Us Answer Your Questions
Not quite ready for a meeting, but you have a question that needs answering? We’re happy to help. Leave an inquiry below, and one of our staff will respond via email.