Some life insurance policies, such as whole life policies and universal life policies, have an investment aspect that builds up cash value in the policies during your life. The cash value grows tax-free in the account, and you are able to withdraw some of it during your life without any income tax implications. However, if you withdraw more than you've paid in, the Internal Revenue Service will be expecting a share of the withdrawal.
Withdrawing Premiums Paid
If you cash out an amount less than or equal to the amount of premium payments in your life insurance policy, you won't have to pay any income taxes on your withdrawal. For example, say you've paid $15,000 in premiums into your policy. If you take out $5,000, you reduce the amount of premiums remaining in the policy to $10,000, but you won't owe any income taxes.
If, on the other hand, you withdraw more than the premiums remaining in your policy, the earnings portion of your withdrawal will be taxable. For example, say you have $10,000 in premiums paid in and the cash value is $16,000. If you take out all $16,000, the last $6,000 counts as taxable income. The withdrawal of earnings is treated as ordinary income, not capital gains income, so it's taxed at the same rate as your wages or salary.
The death benefit paid to your beneficiaries doesn't count as taxable income to them, no matter how large the policy. For example, if you have a $1 million policy on which you name your spouse as beneficiary and the insurance company cuts a check to your spouse upon your death for $1 million, your spouse won't have to pay any income tax on the proceeds. However, interest on the death benefit can accrue between the date of death and the date the insurance company cuts the check, and that interest does count as taxable income to the beneficiary. For example, if by the time the insurance company pays the $1 million policy, $3,000 of interest has accrued (which is also paid to the beneficiary), that $3,000 does count as taxable income.
Life Insurance Policy Loans
If you borrow from the cash value of your life insurance, you won't have any taxes due because you're just taking out a loan. However, if you let the policy lapse, the IRS treats any money you still owe on the loan as a distribution. If that amount exceeds the amount of premiums you've paid, you're going to have some taxable income. For example, say you took out a loan for $50,000 and it has since grown to $60,000 with interest. If you let the policy lapse when you have paid only $45,000 in premiums, you must report $15,000 of taxable income.