How is the cash value growth inside a permanent life insurance policy taxed?

Cash value inside a permanent life insurance policy grows tax-deferred — no income tax is owed on annual interest, dividends, or growth as long as it remains inside the policy. This is one of the tax advantages of permanent life insurance. Tax treatment of distributions: (1) Withdrawals — generally tax-free up to the cost basis (premiums paid), taxable above basis; (2) Policy loans — generally tax-free while the policy is in force (loans are not income, they are borrowed cash value), but if the policy lapses with outstanding loans, the loan amount above basis becomes taxable; (3) Surrender — gain above basis is taxed as ordinary income (not capital gains). MEC (Modified Endowment Contract) policies have different and less favorable tax rules.