Life Insurance and Annuity Tax: Withdrawals, Loans, and MECs

Life insurance and annuity tax rules give both products two powerful advantages: death benefits paid to a beneficiary are generally free of federal income tax, and the cash value or earnings inside the contract grow tax-deferred until you take money out.¹ The catch is that “tax-free” doesn’t stretch across every dollar. What you actually owe depends on whether the money leaves the contract as a death benefit, a withdrawal, a loan, an annuitized payment, or an exchange into a new contract, and each of those paths follows its own rule.

Death Benefits Paid to a Beneficiary

When the insured dies, the beneficiary receives the death benefit free of federal income tax. This applies whether the payout is $50,000 or $5 million, and it covers both term and permanent policies.¹ A lump-sum payment requires no additional reporting beyond what the insurance company handles.

Installment payouts change the picture. If a beneficiary chooses to receive the proceeds over time, the insurer usually holds the funds in an interest-bearing account and pays them out gradually. The original death benefit stays tax-free, but any interest the insurer pays counts as taxable income the beneficiary must report.¹ On a large death benefit, even a modest interest rate can produce a meaningful tax bill.

A separate rule can turn an otherwise tax-free death benefit into taxable income. If a policy is sold or transferred for valuable consideration, the buyer’s later death benefit is only partially excluded from tax. The tax-free portion is limited to what the buyer paid for the policy plus any premiums paid afterward, and everything above that amount becomes taxable when the insured dies. Exceptions cover transfers back to the insured, to a partner or partnership of the insured, to a corporation where the insured is a shareholder or officer, or in transactions where the new owner’s basis carries over from the prior owner.¹ Anyone considering selling a policy in a life settlement should know about this rule before signing.

Tax-Deferred Growth Inside the Contract

Cash value inside a permanent life insurance policy and earnings inside a deferred annuity both grow without being taxed each year. The federal government forgoes billions in annual revenue by leaving this “inside buildup” untaxed as it accumulates.² Practically, your money compounds faster than it would in a taxable brokerage account earning the same return, because no portion is skimmed each year.

Deferral is not elimination. The bill arrives when you pull money out, and how much you owe depends on the contract type and the way you access the funds.

Taking Money Out of a Life Insurance Policy

Owners of permanent policies can reach the cash value while alive, either by withdrawing it or by borrowing against it. The tax treatment is different for each.

Withdrawals

For a standard life insurance policy that hasn’t been overfunded, withdrawals come out first-in, first-out. Your premiums come out first, tax-free, and you only owe income tax once withdrawals exceed your total cost basis in the contract.³ That ordering is favorable. It lets you pull out a meaningful amount before touching taxable gains.

Policy Loans

Borrowing against cash value is not a taxable event as long as the policy stays in force. You receive the loan proceeds without owing tax, and there’s no repayment schedule. The insurer charges interest on the outstanding balance, and if the loan grows large enough relative to the cash value, the policy can lapse.

That is where the tax trap sits. If the policy lapses or you surrender it with an outstanding loan, the IRS treats the forgiven balance as a distribution, and any amount above your cost basis becomes taxable income that year.³ Outstanding loans also reduce the death benefit. Die with a $500,000 policy and a $100,000 loan, and your beneficiary receives $400,000. The reduced amount is still income-tax-free, but the family gets less than expected.

Taking Money Out of an Annuity

Annuity contracts follow a less favorable ordering. For a deferred annuity that hasn’t been annuitized, the IRS applies a last-in, first-out rule: earnings come out first and are fully taxable as ordinary income, and you don’t reach tax-free return of principal until you’ve withdrawn all accumulated gains.³ This is the opposite of life insurance, and it catches owners off guard when they expect their first withdrawal to be tax-free.

The Exclusion Ratio for Annuitized Payments

Once you annuitize the contract and start receiving regular periodic payments, a different calculation applies. The IRS uses an exclusion ratio to split each payment into a tax-free return of your investment and a taxable earnings portion. You divide your total investment in the contract by the expected return over the payout period, which depends on either a fixed term or your life expectancy from IRS actuarial tables.⁴

Suppose you invested $100,000 and your expected total return is $200,000. The exclusion ratio is 50%. Half of each payment is tax-free, and the other half is taxed at your ordinary income rate. That ratio stays the same for every payment, even if cost-of-living adjustments raise the amount. The tax-free portion ends, however, once you’ve recovered your full cost basis. Every dollar after that is fully taxable.⁴ Living longer than the tables predict eventually means paying tax on the full payment.

The 10% Early Withdrawal Penalty

Pulling money from an annuity before age 59½ triggers a 10% additional tax on top of the regular income tax on the taxable portion of the distribution.³ Combined with the earnings-first ordering, an early distribution can be expensive. Withdraw $20,000 in gains at a 22% marginal rate and you’d owe $4,400 in income tax plus a $2,000 penalty, an effective rate of 32%.

The penalty has exceptions. It doesn’t apply to distributions made after the owner’s death, distributions caused by disability, payments structured as substantially equal periodic payments over your life expectancy, or amounts from immediate annuity contracts.³

Overfunded Policies: The MEC Rules

Life insurance normally gets the favorable first-in, first-out ordering, but only if the policy is not overfunded. Congress created the Modified Endowment Contract category to stop taxpayers from using life insurance primarily as a tax shelter.

A policy becomes a MEC if premiums paid during the first seven contract years exceed what it would cost to have the policy fully paid up after seven level annual payments. That’s the 7-pay test.⁵ Your insurer tracks the limit and should warn you before a premium payment would cross the line.

Once a policy is a MEC, two things change permanently. Withdrawals and loans are taxed earnings-first, the same as annuities. And any taxable amount withdrawn or borrowed before age 59½ faces the same 10% early withdrawal penalty.⁵ The death benefit itself stays income-tax-free; MEC status only changes how lifetime access is taxed. Classification is permanent. Once a policy crosses the line, it remains a MEC for as long as the contract exists.

Swapping Contracts With a 1035 Exchange

Federal law lets you trade one insurance or annuity contract for another without triggering current tax. Under a 1035 exchange, the cost basis and built-in gains from the old contract carry over to the new one, so no gain is recognized at the time of transfer.⁶

The statute is specific about which directions qualify:

Life insurance for another life insurance policy, an annuity, an endowment, or a qualified long-term care contract
An annuity for another annuity or a qualified long-term care contract
An endowment for another endowment with the same or earlier start date, an annuity, or a qualified long-term care contract

What’s missing: you cannot exchange an annuity for a life insurance policy tax-free.⁶ Allowing that swap would let someone convert tax-deferred annuity gains into an income-tax-free death benefit.

IRS regulations also require that the same person or persons remain the obligee under both contracts.⁷ The owner and the insured or annuitant need to match across both contracts. Changing them during the exchange disqualifies it, and the IRS treats the transaction as a taxable surrender followed by a new purchase.

Partial exchanges are allowed. You can transfer a portion of one annuity’s cash value into a new annuity, but you cannot take a distribution from either contract during the 180 days after the transfer unless the distribution is in the form of annuity payments spread over at least 10 years or over one or more lifetimes.⁸ A lump-sum withdrawal inside that 180-day window causes the IRS to recharacterize the exchange as a taxable distribution.

One mechanical rule matters above all others: the funds must move directly from one insurance company to the other. Take possession of the money, even briefly, and the entire transaction becomes taxable.

Estate Tax: The Boundary on “Tax-Free”

A death benefit that avoids income tax is not automatically free of estate tax. If the deceased owned the policy or held any control over it at death, the full death benefit is included in their taxable estate.⁹ For large policies, that can push an estate past the federal exemption and generate a 40% estate tax on the excess.

“Incidents of ownership” is defined broadly. It covers the right to change beneficiaries, borrow against the policy, surrender or cancel it, assign or pledge it as collateral, or revoke a previous assignment. Holding any one of these rights is enough. The person doesn’t have to have exercised it.⁹ Transferring ownership away doesn’t help if it happens within three years of death.

For 2026, the federal estate tax exemption is $15 million per individual, a figure made permanent and indexed for inflation by the One Big Beautiful Bill Act signed in mid-2025. Married couples using portability can shelter up to $30 million combined. Estates below these thresholds owe nothing regardless of whether life insurance is included. For wealthier owners, an irrevocable life insurance trust is the standard way to keep the death benefit out of the taxable estate, but it requires giving up all ownership and control over the policy.

1
Office of the Law Revision Counsel. 26 U.S. Code 101 – Certain Death Benefits
2
U.S. Government Accountability Office. Tax Treatment of Life Insurance and Annuity Accrued Interest
3
Office of the Law Revision Counsel. 26 U.S. Code 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
4
Internal Revenue Service. Publication 939 – General Rule for Pensions and Annuities
5
Office of the Law Revision Counsel. 26 U.S. Code 7702A – Modified Endowment Contract Defined
6
Office of the Law Revision Counsel. 26 U.S. Code 1035 – Certain Exchanges of Insurance Policies
7
Internal Revenue Service. Notice 2003-51 – Certain Exchanges of Insurance Policies
8
Internal Revenue Service. RP-2011-38 – Partial Exchange of Annuity Contracts
9
Office of the Law Revision Counsel. 26 U.S. Code 2042 – Proceeds of Life Insurance