The dividends paid on whole life policies come tax free. If you reinvest them in more insurance (paid up additions), they also accumulate tax free. If you hold the dividends in a separate savings account, however, the interest they earn in taxable.
The interest or earnings credited to your cash values in universal life policies is tax free.
If you withdraw dividends from whole life policies or interest from universal life, it is generally not taxed until it exceeds the premiums you have paid. Check on this before taking any money out.
You pay no taxes on money borrowed against virtually all policies on which you pay regular premiums. Partial withdrawals from universal policies may be taxable, however. Ask your agent or company about it.
Single premium policies issued after June 20, 1988, as well as other policies that allow a fast cash buildup, are a special case. They are known as modified endowment policies. If you own one, you owe income taxes on loans you take against the policy up to the amount that the policy has earned. Ditto for any money received when pledging your policy as collateral. You owe a further 10 percent penalty on loans or withdrawals made before age 59 ½ unless you are totally disabled. In that case, you owe taxes but no penalty.
Beneficiaries pay no income tax on the policy proceeds they receive. Any policy you own at death is part of your taxable estate. But the estate will not owe a federal death tax on the policy’s proceeds if you are worth less than the current estate tax exemption or your estate is going to your spouse. State inheritance taxes may be due on smaller estates.
Normally, no estate taxes are due if, before you die, you gave the policy to someone else, like your children or a trust. If you die within 3 years of making the gift, however, the policy proceeds will still be counted as part of the taxable estate.
If you cash in the policy, you will owe income taxes on that portion of the payout (plus loans and loan interest) that exceeds all the premiums you paid minus any dividends not used to buy more insurance. So the money you earn on your insurance cash values is tax sheltered by the premiums you pay.