South Carolina Life Insurance Practice Exam

According to taxation rules, how are cash value increases in life insurance policies taxed?

1. As regular income

2. They are not taxed until withdrawn

3. Taxed at a flat rate

4. Fully taxed at death

The correct answer is: They are not taxed until withdrawn

Cash value increases in life insurance policies are generally not taxed until they are withdrawn. This approach aligns with the tax-deferred nature of life insurance products. When the policyholder contributes to the policy, those premiums can grow over time without triggering immediate tax liabilities. It is when the policyholder decides to access that cash value—through withdrawal, loans, or surrender—that taxes may apply. Withdrawals are taxed on a last-in, first-out basis, meaning that any amounts taken out are considered to come first from the gains in the policy, which are taxable, before impacting the initial premium contributions, which are not taxed. The tax treatment encourages savings and investment within life insurance policies, allowing policyholders to accumulate value without facing immediate tax consequences, thus making option pertaining to the tax being deferred until withdrawal the accurate choice.