Are Life Insurance Payouts Taxable (and when)?

Policy Loans & Cash Value — Pros, Cons, Taxes (IUL Guide for 2025)

Short answer:

• Death benefits from life insurance are usually income-tax-free to your beneficiaries. Interest paid on top is taxable. A few edge cases can make some benefits taxable.

• Cash value in permanent policies (like IUL) grows tax-deferred as long as the policy meets IRS life-insurance rules (§7702).

• Policy loans/withdrawals: Often tax-favored, but can turn taxable if the policy becomes a MEC or lapses/surrenders with a gain.

How the taxes work while you’re alive

• Tax-deferred growth: As long as the policy qualifies under §7702 (CVAT/GPT tests), inside build-up isn’t taxed yearly.

• Withdrawals/loans (non-MEC):

  • Withdrawals are generally tax-free up to your basis (premiums paid, adjusted).

  • Policy loans are typically not taxable if the policy stays in force and is not a MEC.

  • If the policy lapses or is surrendered with a loan and a gain, that gain is taxable—even if you didn’t pocket cash (“phantom income”).

• MEC rules (TAMRA / §7702A): Overfunding too fast can make a policy a Modified Endowment Contract (MEC). Then withdrawals/loans are taxed income-first (LIFO), and 10% early-distribution penalty may apply before 59½. MEC status is permanent.

• Surrender for cash: If you cash out, any amount above your basis is taxable income in that year.

• 1035 exchange: You can often swap to another policy tax-free if done under §1035 (we verify fees/surrenders before recommending).

When are life insurance payouts taxable?

Usually not taxable: If you receive a death benefit because the insured passed away, it’s excluded from income under IRC §101. If the insurer holds the money and pays interest, that interest is taxable.

Cash value & IUL mechanics

With Indexed Universal Life (IUL), your cash value doesn’t go into the stock market. Instead, the insurer credits interest linked to an index (often the S&P 500®) using three dials: a cap (max), a floor (often 0%), and a participation rate (your share of positive gains). That crediting is why IUL can grow with downside buffering.

Policy loans & cash value — pros and cons

Pros

• Access on your terms: Loans don’t require bank underwriting; you can borrow against cash value.

• Potentially tax-favored access: In a non-MEC that stays in force, loans are generally not taxable.

• Flexibility: Choose fixed or variable loan types depending on the carrier.

Cons (manage these!)

• Interest & risk of lapse: Loan interest accrues. If the policy underperforms or isn’t funded, it can lapse—and any gain becomes taxable that year.

• Reduced protection: Outstanding loans reduce the death benefit paid to your family.

Why do this with Fostered Insurance

Fostered Insurance — is a independent brokerage. We compare 63 A-rated life insurers—so you don’t have to. One application. Better value.

IUL tax treatment is powerful—but details matter (caps/floors/participation, loan types, MEC limits, §1035, ownership rules). Because each carrier’s design differs, we shop A-rated companies side-by-side and build an IUL that fits your goals, budget, and tax-smart strategy—in plain English.

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This is education, not tax/legal advice. Tax rules cited from IRC §§101, 72(e), 7702, 7702A, 1035 and IRS Pub. 525/FAQs; actual outcomes depend on your facts and state law. Policy loans/withdrawals reduce cash value and death benefit; if a policy lapses or becomes a MEC, taxes/penalties may apply.