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As with all life insurance policies, the most important reason to own them is the tax-free transfer of a large lump sum to beneficiaries, at the death of the insured. It's a hugely valuable benefit to families and estates, and the protection of loved ones and those depending on you is the primary purpose of all types of life insurance.

The protection of widows and orphans that life insurance provides is so important and so vital, in fact, that Congress has granted life insurance with a number of important tax advantages to encourage people to buy it. While premiums for life insurance are generally not tax-deductible, nearly everything else about permanent life insurance policies, including universal life, variable universal life and whole life insurance enjoys significant favorable tax treatment compared with other financial alternatives.

Tax-free death benefits. As we mentioned, death benefits paid to beneficiaries are generally totally free of federal income tax.

Growth within the policy is tax-fee. As long as your policy has cash value, all growth within that cash value account or variable universal life subaccounts is tax-free. Any commensurate growth in eventual death benefit is also tax-free.

Loans against your policy are tax-free. As your cash value grows, you may wish to access some of the cash for other purposes. There are no age restrictions on this benefit. You can borrow against your policy for any purpose you like penalty free, and free of federal income tax. Use this money to pay college expenses, finance cars, put a down payment on a home, secure a loan, pay retirement living expenses, or anything else you like. You can pay your own policy back, or allow the life insurance company to deduct the balance owed from any eventual death benefit. The choice is yours.

If you are taking Social Security benefits, loans from your policy are not counted against you for the purposes of figuring taxes on Social Security benefits.
Tax Free Exchanges. Under IRC Section 1035, you can exchange your universal life insurance policy for an annuity, free of income tax. This is tremendously useful for anyone who may no longer need or want a life insurance policy (for example, the children are grown) but who has a need or expects a need for income in the future.

If the policy lapses, however, or if you surrender the policy with an outstanding loan, a portion of the cash value may be taxable. Speak with your tax advisor before surrendering or lapsing any life insurance policy.

Estate tax benefits. Personally-owned life insurance contracts are considered part of your taxable estate. However, if you are concerned that your estate may be subject to an estate tax, you can transfer your insurance policy to someone else. If you do so at least three years before your death, it will not be part of your estate, and you will be able to bequeath that much more to your heirs and loved ones.

Given the many tax advantages of permanent life insurance, many owners are tempted to pay as much as they can in premiums, to let premiums compound within their life insurance policies, unmolested by taxation. However, there are limits to how much you can pay in before the policy becomes a 'modified endowment contract,' which makes some of the tax advantages disappear (though the tax-free transfer of assets on the death of the insured remains intact). Your agent can explain this provision and help you maximize the tax advantages of your insurance policy without accidentally triggering the modified endowment contract provision. Speak with your life insurance professional for more details.