Historically, life insurance has been considered beneficial to the public good because it contributes to the financial well-being of families. As a result, there are certain tax benefits for life insurance products. It is important to kow how these come into play with the death proceeds and living benefits of an individual life insurance contract.
Premiums: Policy premiums are considered a personal expense and are not deductible for income-tax purposes. Exceptions to this include premiums that a person paid for life insurance in an alimony agreement or for a policy that is owned by and paid to a charity. In business situations, employers may deduct premiums as a business expense if they are 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 benefits: Death proceeds are generally exempt from income taxation when they are paid in a lump sum.
Accelerated death benefits: For an insured who is terminally ill, the amounts he receives are excludible from income because they are considered as payable by reason of the death of the insured. A physician must certify the terminal illness, which must be expected to result in death within 24 months.
Transfer for value: When a policy is transferred for valuable consideration (according to the IRS, any absolute transfer for value of a right to receive all or a part of the proceeds of a life insurance policy) to another owner, 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 in which 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.
Dividends: The cash dividend is taxable only when it exceeds the cost basis. Dividends are generally taxed on a first-in first-out, or FIFO, basis; withdrawals are treated as a nontaxable return of capital (refund of premium) to the extent of the 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 If dividends are withdrawn or the policy is surrendered, proceeds received in excess of premiums paid are considered ordinary income.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.
Loans: 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.
Cash surrenders: 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 it is received.
Modified endowment contract: The MEC came into being with the 1988 amendment to the tax code (TAMRA, IRC Sec. 72 and Sec. 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 seven-year period. “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 last-in first-out, or LIFO, basis to the extent of gain, subject to a 10 percent penalty, unless the distribution is made after age 59½, or if death, disability or annuitization occurs. 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 Sec. 1035 exchange (see below) is a material change for MEC purposes and is retested. Cash values that are 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.
Sec. 1035 policy exchanges: When a policyowner exchanges an existing life insurance policy in accordance with IRC Sec. 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 Sec. 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.
Glenn E. Stevick Jr., CLU, ChFC, LUTCF, a member of Tri-County AIFA (N.J.), is an LUTC author and editor, and assistant professor of insurance at The American College. Contact him at .