You may think of life insurance as income-replacement protection for your family in the event you or your spouse dies. But what are the tax implications of life insurance?  Here are some important rules to know.

1.) Death benefits. Normally, death benefits paid under a life insurance policy are not subject to income tax. But there are some exceptions. For instance, if you transfer a policy for value during your lifetime (a sale for example), the proceeds received by your beneficiary may be taxable. Exceptions to this transfer-for-value rule exist, including a transfer to your company.

2.) Cash value. With cash-value life insurance, such as a traditional whole life policy, a portion of your premiums goes into an “account” that grows over time. The buildup of cash value during your lifetime is exempt from income tax. You can even borrow against the cash value without adverse tax consequences unless you surrender the policy. One caution: If the premiums you pay during the first seven years exceed certain limits, the policy becomes a modified endowment contract (MEC). MEC rules could result in tax on policy loans and withdrawals.

3.) Accrued interest.  An insurance company may pay interest from the date of death until the actual date the beneficiary is paid.  The interest paid after the date of death is taxable income to the beneficiary.

4.) Exchange of policies. If you replace one life insurance policy with another, the exchange may be tax-free. Typically, you’ll enter into a “Section 1035” exchange when an existing contract is outdated and you’re seeking improved benefits or new features. Be aware that you have to make an actual exchange. You cannot receive a check and apply the cash to a new policy.

5.) Estate tax on proceeds. Generally, life insurance proceeds are subject to estate tax if the insured retains any “incidents of ownership” such as the ability to surrender the policy. You can avoid this result by transferring ownership rights to another person or a life insurance trust.

To ensure the best tax results contact your tax advisor and work with your insurance agent.