How to Save Tax by Understanding the Sale of a Term Life Insurance Policy
An Easy Example
Imagine you own a $2 million term life insurance policy with 10 years left. A family member offers you $20,000 in cash and agrees to pay all future premiums if you name them as the policy’s beneficiary. You accept the deal, thinking it’s a simple exchange, but the tax rules make it more complicated. Understanding how this works can help you avoid unexpected taxes and make smarter financial decisions.
How You Get Taxed
When you receive $20,000 from a family member in exchange for the right to your policy’s death benefit, the IRS views this as a sale for valuable consideration, meaning it treats the deal like an investment transaction.
In simple terms, the IRS sees this just like selling stock or real estate. You’re taxed only on your profit, not the entire amount you received. If you get $20,000 from the sale and had already paid $10,000 in premiums, then your taxable gain is $10,000 after deducting your cost (your basis).
Because term life insurance has no cash value and you’ve owned it for more than one year, that $10,000 is taxed as a long-term capital gain, which is typically taxed at a lower rate than ordinary income. In other words, you save taxes because you’re only taxed on the portion above what you paid in, not the full amount received.
What Happens if You Die During the Policy Term
If you had kept the policy in your name and your wife was the beneficiary, she would receive the full $2 million death benefit tax-free. That’s one of the biggest advantages of life insurance—it’s designed to protect loved ones without creating a tax bill.
However, if you sell the policy to a family member, the situation changes dramatically. Because they paid for the policy, the IRS treats them like an investor. They can exclude from income only the total they paid for the policy plus any premiums they paid afterward. So, if they paid $20,000 for the policy and another $20,000 in premiums, only $40,000 of the $2 million would be tax-free. The remaining $1,960,000 would be taxed as ordinary income.
This happens because the IRS sees their purchase as an investment, not a personal insurance benefit. Think about it this way: they’re betting that you’ll pass away during the term, or else they lose their money. Since it’s an investment, the profit—meaning the death benefit minus what they paid—is taxable.
If You Outlive the Policy Term
If you live beyond the 10-year term, the policy simply expires and becomes worthless. The person who bought it cannot claim a capital loss because the IRS doesn’t recognize the expiration as a deductible event. They also can’t deduct the premiums they paid because life insurance premiums aren’t deductible when you’re also the policy beneficiary.
In this situation, the buyer loses their investment and gets no tax benefit, which makes buying someone else’s term policy a poor financial decision for most people.
The Takeaway
When you sell your life insurance policy, the IRS treats it like an investment sale. You are only taxed on your profit, which is the amount received minus what you paid in premiums.
When someone else buys your policy, the IRS sees their purchase as an investment, so the death benefit they collect later is mostly taxable because their “profit” is treated as income.
When a term policy expires, there is no tax deduction or write-off.
In short, selling a term life policy usually does not save taxes, and it can eliminate the tax-free benefit your family would otherwise receive. If your goal is to provide financial security for loved ones and minimize taxes, keeping the policy in your name and making your spouse or family member the beneficiary is almost always the smarter choice.
