First and foremost, the primary purpose of all forms of life insurance is to provide a death benefit when the insured dies. Benefits paid to a beneficiary from a life insurance policy due to the death of the insured are generally tax-free. There are occasional exceptions where the life insurance has been purchased by a third party as an investment, but this doesn't apply to the vast majority of policies designed to protect a loved one, a business partner, or someone with a legitimate insurable interest in the life of the insured.
Furthermore, as long as there is a named beneficiary on the policy, life insurance benefits don't go through probate. They are therefore not subject to the claims of any creditor on the insured or the policy owner, including the claims of the IRS. If the insured tried to leave cash or mutual funds or any other asset besides an insurance product to the beneficiary, the IRS and other creditors would take money owed them out of the estate first. Heirs would receive only what is left over. If there is a named beneficiary, the life insurance policy bypasses probate and is paid directly to the beneficiary.
If there is no named beneficiary, or the named and contingent beneficiaries are deceased, then the death benefit goes to the estate, and the entire estate, including the life insurance benefit, goes through probate. That is why you should ensure you have a named beneficiary on your policy, and periodically review your policies and verify your beneficiaries are still alive and they are still the people whom you want to receive the death benefit.
Accumulation of Cash Values
Whole life and universal life policies build up cash value over time. As long as the money is left within these policies, and the policies do not lapse, your cash value accumulates tax-deferred, and will accumulate tax-free if left alone to pay a death benefit. There are no income taxes and no capital gains taxes on any assets left to accumulate within a life insurance policy.
If your policy accumulates non-guaranteed dividends, you may withdraw them from the policy, tax-free - the IRS considers dividends to be a return of capital to you, not income. Once you have withdrawn all your available dividends, you may borrow against the cash value - again, generally tax free, provided the policy has been structured properly. You can pay back the loan to your insurance company, or the insurance company will pay itself back, with interest, and subtract that amount from the eventual death benefit it pays.
You can use this cash for any purpose - to fund a business, to buy a home, pay off a mortgage, or even supplement your retirement income. The net tax effect is similar to contributing to a Roth IRA - you pay in premiums using after-tax money, but if you structure it properly, it can generate tax-free income for you to use for any purpose you like. Meanwhile, there are no required minimum distributions, and no penalties if you access the money prior to turning age 59½.
Surrendering the Policy
If you surrender the policy, you will generally receive back your accumulated cash value. You may be liable for capital gains tax on any cash value you receive as a result of surrender, based on your cash value minus amounts you paid into your policy. That is, you will pay taxes on gain over basis.
Discuss your options with a HALO Insurance agent, call 314-351-HALO (4256).