The general rule is that the annual increase in the cash surrender value of your life insurance policy does not result in current tax liability. The cash value is allowed to build up on a tax-deferred basis until:
Until one of these events occurs, you have substantial limitations and restrictions on your receipt of the cash value of the policy. Accordingly, the cash value is allowed to build up on a tax-deferred basis. However, there are a number of important exceptions to the general rule.
The cash value of the following contracts does not build up on a tax-deferred basis:
Tax on increases in the cash surrender value of a policy issued after December 31, 1984, that does not meet the Internal Revenue Code’s definition of a life insurance contract is generally not deferred.
The tax-deferred status of contracts issued before 1985 does not hinge on the statutory definition of a life insurance contract, but case law on the subject reaches the same result. Consult additional resources.
Calculation of current tax liability for such policies can be complicated. Again, consult additional resources.
If the failure to meet the statutory definition is a result of reasonable error and steps are being taken to rectify the matter, the IRS can opt to waive disqualification.
With the exception of certain contracts that were grandfathered, the underlying investments of the segregated asset accounts of a variable contract must meet the IRS’s diversification requirements. See Annuities, Variable Annuities. If it does not, then the buildup of cash value may be taxed even though the contract qualifies as an insurance contract under state law and meets the IRS’s definition of a life insurance contract.
The cash value of a corporate-owned life insurance policy may not build up on a tax-deferred basis. The buildup is taken into account during computation of the corporation’s alternative minimum tax.