How is life insurance taxed?
Historically, life insurance has received favorable tax treatment. As insurance products have become more complicated, however, the line separating insurance products from investment products has become blurred. As a result, a mix of complex rules and exceptions now govern the taxation of insurance products.

First, what exactly is life insurance?
Life insurance provides you with many tax advantages, but only if it is life insurance.  For tax purposes, life insurance is only life insurance if the IRS says it is life insurance. If the terms of a life insurance contract do not meet the IRS's statutory definition, you are not entitled to the tax advantages.

What is the IRS definition? It depends on the type of policy and when it was issued. Basically, though, the IRS definitions are actually more like tests to be sure that a policy isn't really more of an investment vehicle than an insurance policy.

Tax considerations
Taxes are typically levied whenever cash changes hands. During the term of any life insurance policy, there are a number of occasions when money can and does change hands. The only question is whether the transaction amounts to a taxable event that triggers current income tax liability. For instance, in most cases, premiums are paid with after-tax dollars. To the extent they are deemed a return of premiums, benefits paid out during your lifetime are usually paid out tax-free. Typically, your beneficiaries receive death benefits tax-free after your death. But, the sale or surrender of your policy during your lifetime triggers a tax on the realized gain.

Here are a few things to remember:

Premiums may be paid with pre-tax dollars
Cash value accumulates tax deferred.
Dividends are typically not taxable
Cash withdrawals in excess of basis are taxable income
Policy loans usually not taxable
Interest on policy loans usually not tax deductible
Surrender of policy may result in taxable gain
Policy exchanges are typically not taxable
Death benefits are usually not subject to federal income tax
Insurance proceeds may be included in your taxable estate