Death Benefit

• The death benefit of a whole life policy is excluded from income taxation. Your beneficiaries receive the death benefit when you die. They choose between a lump sum amount or several other payment options, which include leaving the death benefit to accumulate interest with the insurer or annuity payment options. While the death benefit is tax-free, any investment interest earned on it is taxable as ordinary income. The only time you pay income taxes in connection with the termination of a whole life policy is if you sell the policy to a third party, a life settlement company. A settlement company buys your policy for an amount between the cash value amount and the death benefit. In this case, the tax you pay is based on the difference between what the settlement company buys your policy for and what the death benefit is. You pay capital gains taxes on this amount.
  
  

Cash Value Surrender

• The cash value portion of the policy is income tax-free as long as the policy remains in force. When you surrender a whole life policy, you pay income taxes on all of the money in excess of the premiums you've paid into the policy. The amount you pay in premiums is called your cost basis. Any amount in excess of this is called your gain in the policy. A gain in the policy is subject to ordinary income tax. This tax must be paid when you file your next tax return.
  
  

Estate Tax

• You may be required to pay estate and inheritance tax. Federal estate tax is determined by adding the value of the death benefit to all of your other assets. If this amount exceeds $5 million, then you pay an estate tax based on any value in excess of $5 million. State inheritance tax varies by state. You pay an amount that coincides with your state's rules regarding an inheritance.
  
  

1035 Exchange

• You may terminate your policy and exchange it for an annuity policy. An annuity is an insurance contract that functions like savings. This money is intended to be used as retirement savings. The IRS allows you to convert your whole life policy to an annuity using a 1035 exchange. No income tax is triggered when you do, regardless of whether you have a gain in the policy or not.