How is Life Insurance Taxed
Historically, life insurance has been considered beneficial to the public good because it contributes to the financial preservation of families. As a result, certain tax benefits are provided for life insurance products. This discussion will summarize the main points of federal income taxes for death proceeds and living benefits of an individual life insurance contract.
Premiums are considered a personal expense and are not deductible for income tax purposes. Exceptions include premiums paid for life insurance in an alimony agreement and premiums paid for a policy owned by and paid to a charity. In business situations, employers may deduct premiums as a business expense if paid in the form of a bonus to the employee. If life insurance is part of a pension plan, employer paid premiums are deductible.
Death proceeds are generally exempt from income taxation when paid in a lump sum.
Accelerated Death Benefits
Amounts received for an insured who is terminally ill are excludable from income as amounts payable by reason of the death of the insured if certain conditions are met. Terminal illness must be certified by a physician, and the illness must be expected to result in death within 24 months.
Transfer for Value
When a policy is transferred to another owner for valuable consideration, part of the death benefit becomes taxable. The taxable amount is the death benefit reduced by the amount paid to transfer the policy and the premiums made by the new owner. Transactions exempt from this rule include situations where the policy is sold to the insured.
Matured Life Contracts
When a policy reaches the maturity date, the proceeds are not considered a death benefit, and any gains in the policy are considered ordinary income for the tax year in which they are distributed. Gains are amounts received in excess of the cost basis, the amount paid with after-tax money.
The cash dividend is taxable only when it exceeds the cost basis. Dividends are generally taxed on a first-in first out (FIFO) basis; withdrawals are treated as a nontaxable return of capital (refund of premium) to the extent of premiums paid. If dividends are withdrawn or the policy is surrendered, proceeds received in excess of premiums paid are considered ordinary income. If dividends accumulate at interest, the interest earned is taxable.
Policy loans are normally not taxable. If a policy is surrendered with a loan outstanding, and if that loan, with other cash value, is greater than the cost basis, there is a taxable gain.
Upon surrender it must be determined if the amount received exceeds the net premiums paid. Net premiums paid means the gross premium less any dividends received and outstanding loans. The difference is reportable as ordinary taxable income in the year received.
Modified Endowment Contract (MEC)
The modified endowment contract (MEC) came into being with the 1988 amendment to the tax code (TAMRA, IRC Section 72 and Section 7702A). People were putting large sums of money into policies to accumulate funds on a tax-deferred basis. TAMRA provided that if a policy was over-funded (whether at issue or at a later date), it would be classified as a MEC, and any distribution representing a gain from the policy would be taxed.
The seven‑pay test establishes limits to the amount of premiums that can be paid within a period of 7 years. “Material changes” that occur to an in-force policy can cause a policy to be retested as if the changes existed since the beginning of the policy.
If a policy is or becomes a MEC, distributions will be taxed on a LIFO (last‑in‑first‑out) basis to the extent of gain, subject to a 10-percent penalty unless the distribution is made after age 59½ or death, disability, or annuitization occur. Distributions include policy loans, cash dividends, withdrawals and surrenders
If a policy becomes a MEC, it is “tainted” for as long as it exists and carries over to any policy that is issued in exchange for a MEC. A Section 1035 exchange (tax‑free exchange where one policy is exchanged for another meeting certain rules) is a material change for MEC purposes and is retested. Cash values transferred from the existing policy will not count as premium. If the policy fails the material change test, it will be classified as a MEC.
Section 1035 Policy Exchanges
When a policyowner exchanges an existing policy in accordance with IRC Section 1035, no gain is attributed on the exchange. The adjusted basis of the old policy is carried over to the new one. Only the newly added premium will be measured for MEC status. A section 1035 exchange is allowed only when transferring cash values from an annuity to an annuity, life insurance to life insurance, or life insurance to an annuity contract.
The Pension Protection Act allows the proceeds of a life or annuity policy that qualify for a 1035 Exchange to be placed in a Long-term care policy without a taxable event.
Glenn E. Stevick, Jr., ChFC®, CLU®, LUTCF is an assistant professor of insurance at The American College.