Life insurance policy tax treatment for retirees: surrender, maturity, and death proceeds

For Australian retirees who hold life insurance policies — whole-of-life policies, endowment policies, term life policies, or similar protection-and-savings products from earlier in life — the tax treatment on the eventual disposition of the policy is generally favourable but worth understanding before making decisions. Many retiree clients hold policies they took out decades ago, when whole-of-life and endowment policies were standard products combining death benefit protection with a forced-savings investment component. The policies have accumulated substantial cash value over many years, and the retiree faces choices: continue paying premiums; surrender the policy for its current cash value; or hold the policy until eventual death for the larger death benefit. The tax treatment is governed primarily by section 118-300 of the Income Tax Assessment Act 1997, which exempts CGT on the disposal of a life insurance policy by the original beneficial owner — meaning the retiree who originally purchased the policy can surrender or otherwise dispose of it without triggering a capital gain. Combined with the tax-free treatment of death benefit proceeds in the beneficiary's hands, the tax framework is mostly supportive of either strategy. The decision between surrender and continuation is therefore primarily a financial and protection-need question rather than a tax-driven one.

The types of life insurance relevant to retiree planning are several. Term life insurance pays a death benefit if the insured dies during a specified policy term; the policy has no investment component, no cash value, and simply lapses if the insured outlives the term without claiming. Whole-of-life policies pay a death benefit whenever the insured dies (the policy doesn't lapse) and include an investment component that grows over time as a cash value, also called the "surrender value," that can be accessed if the policy is surrendered before death. Endowment policies pay a benefit on the earlier of the insured's death or a specified maturity date (commonly age 65 or another nominated date); the investment component matures at the same time, allowing the retiree to receive the policy's accumulated value at the maturity date even if they are still alive. Insurance bonds — investment products structured legally as life policies but designed for investment rather than insurance — have their own tax treatment under section 26AH of the Income Tax Assessment Act 1936 (the "10-year rule") and are covered separately. Life insurance held within superannuation has different tax rules — the proceeds flow as super death benefits and are taxed under the super death benefit framework (tax-free to dependants, taxable to non-dependants on the taxable element). For our purposes here, the focus is on personally-held life insurance policies — those owned directly by the retiree outside super.

The CGT exemption under section 118-300 is the foundation of the favourable tax treatment for personally-held life insurance. The provision exempts CGT on the disposal of a life insurance policy by the original beneficial owner — the person who initially took out the policy and has held the beneficial interest in it. For a retiree surrendering a policy they took out 35 years ago, the surrender is CGT-exempt; the cash surrender value flows tax-free into the retiree's hands. The exemption applies regardless of how much the policy has appreciated since inception — a policy with $30,000 of premiums paid over 35 years that now has a $150,000 cash surrender value can be surrendered without any CGT consequence. The exemption is limited to the original beneficial owner: if the policy was acquired by another person during the original owner's lifetime (e.g., through assignment), the subsequent owner may not have the same exemption on their later disposal — but this scenario is unusual in practice.

The section 26AH "10-year rule" is the second tax layer that needs attention for whole-of-life and endowment policies issued after 27 August 1982. Bonuses declared on these policies and received by the policyholder within the first 10 policy years are partially or fully assessable income, separate from CGT: full inclusion in assessable income for bonuses received in years 1-8; two-thirds inclusion if received in year 9; one-third inclusion in year 10; and zero inclusion (fully tax-free) beyond 10 years. For retirees holding decades-old policies, the 10-year rule is therefore long past — surrender, maturity, or claim payments are received free of any s 26AH inclusion. The provision matters mainly for clients considering an early surrender of a relatively new policy, which is not the typical retiree scenario.

The death benefit proceeds are similarly tax-favoured in the beneficiary's hands. When the insured dies and the life insurance policy pays the death benefit to a nominated beneficiary or to the estate, the proceeds are not assessable income in the recipient's hands — life insurance death benefits are not subject to income tax in Australia. This is true whether the policy is personally owned (death benefit paid to the named beneficiary) or held through a trust (death benefit paid to the trust, then distributed per the deed). The treatment is different if the policy is held within superannuation — the proceeds flow as super death benefits subject to the super death-benefit tax rules: tax-free to dependants of the deceased, but taxable in the hands of non-dependants on the taxable component, capped at the 17% (taxed element) or 32% (untaxed element) concessional rates. For personally-held policies, the unconditional tax-free death benefit treatment is one of the powerful features that makes life insurance useful in estate equalisation strategies — providing a tax-free lump sum to nominated beneficiaries.

The policy bonus treatment for whole-of-life and endowment policies sits alongside the s 26AH rule. Many older policies declare annual reversionary bonuses and a terminal bonus — additions to the policy's cash value over time. The insurance company has paid tax at the life-company rate on the underlying investment earnings before declaring the bonus, so the cash value passed to the policyholder already reflects post-tax earnings. Once a policy is more than 10 years old, the s 26AH inclusion drops to zero and the bonus declarations flow to the policyholder without further tax — making the after-10-year accumulated value a fully tax-paid amount in the policyholder's hands.

The surrender vs hold decision is primarily a financial and protection-need question rather than a tax-driven one. The cash surrender value is typically substantially less than the death benefit — surrendering means giving up the future larger death benefit in exchange for the smaller current cash. The decision depends on whether the retiree's dependants still need the protection (children grown, spouse adequately provided for, mortgage paid — the original protection rationale may have ended); the ongoing premium cost (some older policies have premiums that escalate over time, so the retiree may be paying more than the death benefit justifies); the retiree's cash needs (surrendering provides immediate cash; holding preserves the larger eventual death benefit); the estate planning value (some retirees hold life insurance specifically for estate equalisation, providing a tax-free lump sum that balances distributions among children where other assets are uneven or indivisible); and the cash flow position (continuing premiums requires ongoing cash flow; surrendering ends the obligation). For retirees whose dependants have grown beyond the need for protection and who don't have specific estate-equalisation reasons to hold the policy, surrendering for the cash value is often the rational choice. For retirees with specific estate-planning intent or with ongoing dependant needs, continuing the policy may be warranted.

The Centrelink treatment of life insurance reflects only the current cash value, not the death benefit value. A whole-of-life policy with a $200,000 death benefit but a $40,000 cash surrender value is assessed by Centrelink at $40,000 — the surrender value, because that is the amount currently accessible. The death benefit value is irrelevant to the Centrelink assessment because it is not currently accessible. Premium payments are not directly income-test relevant — they are an expense rather than income. When the insured dies and the death benefit is paid to a beneficiary, the lump sum becomes an asset for the beneficiary under their own Centrelink circumstances. For retirees deciding whether to continue paying premiums, the Centrelink consequence is that the surrender value is currently an asset and continues to be assessed at the surrender value through the years.

What do worked planning examples show?

These two cases show how life insurance tax treatment plays out in practice. Illustrative only — not personal advice — using FY25-26 figures.

Case 1 — Robert, 71, holds a whole-of-life policy he took out in 1985 when his children were small. The policy has a $200,000 death benefit and a $65,000 cash surrender value. The annual premium is $2,400 (which has crept up over the years). His children are now in their 40s and financially independent. His wife is comfortably provided for through joint super and home ownership. On these facts, the original protection rationale has ended. The policy is 41 years old, so well beyond the 10-year window of s 26AH; under s 118-300 the surrender by Robert as original beneficial owner is CGT-exempt, and the $65,000 flows to him tax-free. He saves $2,400 a year in premiums going forward. The decision means giving up the future $200,000 death benefit — but with no current dependants needing the protection, this is a reasonable trade-off. On these facts the rational steps are to surrender the policy, redeploy the $65,000 into super via an NCC contribution within the $120,000 FY25-26 cap (or invest it personally if super cap room is constrained), redirect the $2,400/year premium saving toward retirement living costs, and simplify the financial picture. Robert could also weigh the estate-equalisation value of the death benefit — but with three equally-placed adult children and a separately-provided spouse, the equalisation argument doesn't have weight on these facts.

Case 2 — Margaret, 68, holds a whole-of-life policy from 1990 with a $300,000 death benefit and $80,000 cash surrender value. She has three children: one daughter who is intellectually disabled (and the beneficiary of a Special Disability Trust), and two adult sons who are financially independent. Margaret's main asset is the family home; she plans to leave it equally to the three children but wants to provide additional separate provision for her disabled daughter. On these facts, the life insurance has specific estate-planning value as a dedicated provision for the disabled daughter. On Margaret's death the $300,000 death benefit pays tax-free (life-insurance death benefits are not assessable to the recipient) directly to the daughter or her Special Disability Trust, providing dedicated additional support beyond her share of the home. The two sons receive their share of the home through the will, equally; the daughter's enhanced share comes from the life insurance, not from the home estate, which keeps the home distribution equal and avoids family-equity friction. On these facts the rational steps are to continue the policy with the daughter or the SDT nominated as beneficiary, document the rationale in the broader estate-planning file, and review the cost of premiums annually against the protection value. The ongoing premium is the explicit cost of providing the daughter-targeted benefit. The general point is that life insurance can have specific estate-planning value beyond raw financial analysis — particularly in families with disabled dependants or other equalisation needs.

For retirees with life insurance policies from earlier in life, the tax treatment is mostly favourable — surrender is CGT-exempt under s 118-300 for the original beneficial owner, the s 26AH 10-year rule has long since closed for any decades-old policy, and death proceeds are tax-free to the beneficiary. The decision between surrender and continuation is therefore primarily a question of whether the protection or estate-planning purpose continues to be relevant. The advice work is to inventory life insurance holdings (including any held in old super accounts), confirm policy details (sum insured, cash value, ongoing premium, terms, beneficiary nomination), evaluate ongoing need against the original protection rationale, identify any specific estate-planning purpose for retaining the policy, recommend surrender where the protection rationale has ended and there is no estate-equalisation need, recommend continuation where the policy serves an ongoing purpose, and integrate the decision with broader Centrelink, super and estate planning. For too many retirees, old life insurance policies continue on autopilot through years of premium payments without active review — the inventory and review is worthwhile at retirement and periodically thereafter.

Sources

• Australian Taxation Office (ATO) — Print
• Australian Taxation Office (ATO) — Document
• Australian Taxation Office (ATO) — Document
• Australian Taxation Office (ATO) — Superannuation death benefits
• Services Australia — Asset types