Definition of Life Insurance

• Life insurance is generally defined by various laws, including the Technical and Miscellaneous Revenue Act of 1988, Tax Equity and Fiscal Responsibility Act of 1982, Deficit Reduction Act of 1984. Collectively, these are known as TAMRA, TEFRA, and DEFRA. These laws define a life insurance contract, specifying how premiums are to be paid, and how cash values must accumulate inside the policy to be considered a life insurance policy. If your life insurance policy violates any of these rules, the policy will be treated more like a non-qualified retirement account (i.e. an annuity) instead of a life insurance contract. Fortunately, life insurance companies actively protect policy holders from doing this on purpose.
  
  

Deduction of Premiums

• Premiums are generally not deductible for any reason other than as a business expense. Even still, a business must show that the policy is not being used purely for a tax deduction or some tax reduction strategy. An example of a legitimate tax deduction for premiums would be a company purchasing life insurance on an executive where the company was not named as a beneficiary on the policy.
  
  

Taxation of Cash Values

• Generally speaking, cash values are not taxable. The accumulated cash value build-up is considered tax-exempt.
  
  

Taxation of Withdrawals and Loans

• Withdrawals from life insurance policies are not taxable up to your basis in the policy (the amount of premiums you've paid into the policy so far). Once you have recovered your basis from the policy, all gains are taxable at ordinary income tax rates. Policy loans are not taxable unless the policy lapses. At this point, loans are forgiven and considered income subject to income tax. Any gain, which means any amount above and beyond your basis in the policy, will be subject to income tax.
  
  

Misconceptions

• A common misconception is that life insurance is "tax free." While this is generally true (at least in terms of the effect), life insurance is technically "tax advantaged." Taxes on cash values are "deferred" until withdrawals above the cost basis are made, or until the policy lapses. In practice this rarely happens, however, it could and is something to be aware of.