The tax treatment of life insurance is important to understand as you plan for your future.
The death benefit of a life insurance policy is income tax-free to the beneficiaries, but can be subject to estate taxes if the insured estate is large enough. In 2009, the exemption is 3.5 million dollars that you can pass to heirs with no estate taxes. If you have an estate that has a value above the exemption level, you can be subject to paying the estate tax on the amount above. While the exemption stands at 3.5 million in 2009, it goes away for 1 year in 2010 and returns at the 1 million dollar level in 2011. The tax rate in 2009 can be up to 45% and in 2011 it can be up to 55%. The way they have set it up is pretty strange and how it is set up could completely change in the near future. One of the ways people avoid paying the estate tax on their life insurance is to keep it outside of the estate in an ILIT (irrevocable life insurance trust). When that money comes in to the family, they can use it to pay the immediate estate tax bill. Life insurance death benefits are sometimes taxable in some business scenarios, but not usually with individuals.
The cash value of life insurance grows tax-deferred and can be accessed tax free if used correctly. There is a limit on how much money can be stuffed inside a permanent life insurance because of its tax preferred status. If the amount deposited exceeds the policy limit than the policy becomes a MEC (modified endowment contract). Under IRS guidelines, the policy then becomes income taxable. If the policy is surrendered and the policy is cashed out, then the growth in the cash value would be subject to taxation. The correct way to access the money is through withdrawals up to the cost basis and then preferred policy loans.
The premiums are typically are not deductible, except in some business applications.