Policies that combine investments with insurance — including whole life, universal life and single-premium life policies — enjoy tax-favored status.

Part of your premium is invested. Earnings on the cash value are not taxed until you cash in the policy. If the policy is in force when you die, the proceeds go to your beneficiary completely free of any federal income tax.

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Loans and Withdrawals
With single-premium policies, you pay the premium only once. The death benefit is small, but the entire premium immediately starts earning interest or may be invested in your choice of various stock and bond funds. The cost of insurance comes out of your earnings.

The earnings accumulate tax-free, just as money in an individual retirement account.

Until recently, you could borrow against the single-premium policy. Interest on the loan was offset by earnings that continued to be credited to your cash value. While Congress no longer allows tax-free loans on a single-premium policy, if you pay premiums for at least 7 years, a policy loan isn’t considered a taxable withdrawal.

Some policies allow partial tax-free withdrawals of cash value. The IRS assumes that the first money pulled out is a return of your premiums rather than the earnings. When withdrawals exceed your total investment in the policy, however, additional withdrawals are considered taxable income.

Annuities
An annuity is a contract between you and a life insurance company under which you make a lump-sum payment or series of payments. In return, the insurer makes periodic payments to you beginning immediately or at some future date.

Annuities typically offer tax-deferred growth of earnings and may include a death benefit that will pay your beneficiary a guaranteed minimum amount, such as your total purchase payments. There are two types of annuities:
  1. Fixed annuity: You receive a definite amount of money for a specified period of time — for example, $400 a month for life. With a fixed annuity, your investment earns interest at a rate set by the insurance company, a rate that can change periodically in line with market interest rates.
  2. Variable annuity: The amount of the payments you receive may vary, depending on how your investments perform. You have a choice of several funds — stock, bond, money-market, etc. — and your return depends on the success of the investments you choose.
No tax is due until you pull funds out of the contract, presumably in retirement, either in a lump sum or by annuitizing the contract and having the company make payments to you for life.

If you want to withdraw earnings early, most contracts impose surrender charges during the first several years. Any earnings pulled out of the annuity are taxable, and if you're younger than 59½, you'll pay a 10% penalty tax. 

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