South Carolina Life Insurance Practice Exam

How are cash value growths in a life insurance policy treated for tax purposes?

1. Taxed as ordinary income

2. Tax deferred

3. Potentially taxable upon death

4. Taxed only if the policy is cashed in

The correct answer is: Tax deferred

The growth of cash value in a life insurance policy is typically treated as tax-deferred. This means that the increases in cash value are not subject to income tax while they remain within the policy. The policyholder can accumulate savings over time without the immediate tax implications that would arise from other forms of investment income. When the policyholder eventually takes withdrawals or loans against the cash value, any gain may be subject to taxes. However, as long as the funds remain within the policy and the policy is in force, the growth is sheltered from taxation. This tax-deferred growth is one of the appealing features of permanent life insurance policies, incentivizing individuals to use them for long-term financial planning and wealth accumulation. Understanding that these cash values won't incur taxes until specific actions are taken reinforces the benefits of using life insurance as part of a broader financial strategy.