• Life insurance is designed to provide a tax-free death benefit to anyone who would be financially harmed by an individual's death. People employ life insurance for a variety of reasons, including to replace lost income, cover funeral costs, allow a grieving breadwinner to stay at home with children following the loss of a spouse, to provide liquidity to pay expected estate taxes on illiquid estates, and to fund buy-sell agreements between business owners, among other purposes. The United States government has historically recognized the importance of life insurance in most portfolios and has provided a number of tax benefits to encourage its purchase.
  
  

Tax-Free Death Benefit

• Normally, a life insurance policy's death benefit goes to beneficiaries tax-free. However, if the policy is sold for cash or another consideration, the death benefit may become taxable under a set of laws called "transfer for value" rules.
  
  

Tax-Free Build-up of Cash Value

• When cash value accumulates within a permanent policy, such as a whole life or universal life policy, the interest or dividends compound tax-free.
  
  

Consequences of Transfers

• You may transfer life insurance cash value into an annuity or another life insurance policy tax free, under Section 1035 of the Internal Revenue Code. These transfers are called 1035 exchanges.
  
  

Consequences of Policy Surrender

• If you surrender your policy and the insurance company sends you a check for your cash surrender value, you are subject to paying capital gains tax on the value of the policy minus the amount of your investment, or "basis."
  
  

Consequences of Borrowing

• Generally, you face no tax consequences on borrowing money against the cash value of your life insurance policy. The IRS considers the transaction a loan, not income. However, if you do not pay the policy back, you will lose the commensurate amount of tax-free death benefit.
  
  The general rule allowing for tax-free borrowing has an exception. If you try to invest too much into a life insurance policy too fast, the IRS could declare your policy to be a modified endowment contract (MEC). This disallows tax-free withdrawals or loans. Under MEC rules, life insurance cash value is taxed similar to annuities: It receives tax-deferred growth and is taxed as income on withdrawal.
  
  

Estate Planning Consequences

• If you own a life insurance policy on yourself in your own name, the death benefit becomes part of your estate and is considered potentially taxable under estate tax laws. To avoid this issue, have someone else own the policy or place the policies in an irrevocable life insurance trust. This gets the policies out of your estate, although you also give up direct control of the policies and lose access to any cash value that may accumulate.