Taxation of Individual Life Insurance

Taxation of Individual Life Insurance


The popularity of life insurance is due in large part to the favorable income tax treatment it receives under the U.S. Tax Code. This lesson looks at the taxation of individual life insurance.

Tax Treatment of Premium Payments

Life insurance premiums are generally not tax deductible, whether the insurance is used for personal or business purposes.

There are a couple notable exceptions:

  • When the insured pays the premium of a life insurance policy he or she donated to a charitable organization, the premium is a tax-deductible charitable contribution.
  • When the ex-spouse pays for life insurance as part of a divorce decree, the premiums are tax deductible as alimony.

Income Taxation of Life Insurance Death Benefits

Life insurance death benefit proceeds are generally income tax free. (A possible exception to this is the transfer-for-value rule, discussed below.) This income tax exclusion makes life insurance an attractive financial and estate planning tool.

The interest earned on death benefit settlement options involving proceeds left with the insurer (e.g., period certain only option) are subject to income taxation in the year earned (whether paid out then or not). The death benefit principal retains its income tax-free status, regardless of when it is paid out.

Transfer-for-Value Rule

While life insurance death benefits generally avoid income taxation, there is a notable exception. It is called the transfer-for-value rule. With a few key exceptions, if a life insurance policy is “transferred for value” (i.e., sold) to another party, a portion of the death benefit proceeds is taxable to the beneficiary.

The portion of the death benefit subject to taxation is the policy’s gain, calculated as follows:

death benefit – sum of new owner’s purchase price and premiums paid = policy gain (taxable)

Example

Leo owns a $100,000 policy on his life. He sells the policy to his younger brother, Bruno, for $50,000. Bruno names himself as beneficiary. Bruno is now responsible for paying the policy's annual $1,000 premium.

Four years after the sale, Leo dies, and Bruno receives the policy's $100,000 death benefit. Bruno's taxable "gain" in the policy is $46,000, based on the following calculation:

$100,000

(the death benefit)

– $50,000

(the purchase price)

– $4,000

(the premiums Bruno paid)

$46,000

(Bruno's gain in the policy)

Exceptions to the Transfer-for-Value Rule

Several types of transfers do not fall into the transfer-for-value rule category. If a transfer is made in any of the following situations, then the death benefit is not taxable:

  • a policy is sold by the current owner to the insured person
  • a policy is sold to a business partner (or the partnership) of the current owner
  • a policy is sold to a corporation in which the current owner is an officer or shareholder

Estate Taxation of Life Insurance Death Benefits

The death benefit of a life insurance policy owned by the insured at death is included in the insured’s estate. This includes policies that were transferred to a third party by the insured within three years prior to death (in which case, the transfer is subject to the bring-back rule).

Whether there is a tax consequence to having a policy included in one’s estate depends on the total value of the decedent’s estate:

  • If the decedent’s estate is valued greater than the current estate tax exclusion amount, the policy’s death benefit is subject to estate taxation. For this reason, affluent life insurance applicants are generally advised to make the policyowner someone other than the insured.
  • If the estate value is less than the exclusion amount (as it is with most Americans), the estate is not subject to taxation, and therefore, neither is the life insurance policy.

Income Taxation of Life Insurance Cash Values

Life insurance cash values grow tax deferred. If paid out as part of the death benefit, they effectively become income tax free.

However, if the cash value is distributed before the insured’s death, the picture gets more complicated. The question of taxability then hinges on whether the distribution is due to a policy loan or a cash value withdrawal (i.e., full or partial surrender).

Policy Loans

Policy loans are not cash value distributions but loans by the insurer, which uses the cash value as collateral. Since no withdrawal is being made from the cash value, no taxes are owed. There are two notable exceptions:

  • If the policy is later surrendered, then unpaid loan balances are paid off using the cash value. At that point there may be an income tax liability to the extent the outstanding loan balance includes gain (i.e., it exceeds the sum of premiums paid).
  • If the policy is a modified endowment contract (MEC), the loan is taxable.

Policy Surrender

Cash value withdrawals from life insurance are generally treated on a favorable "first-in/first-out" (FIFO) basis for tax purposes, which means withdrawals are treated first as a non-taxable return of premiums. This is true whether the withdrawal is associated with a partial surrender (e.g., a cash value withdrawal from a universal life insurance policy) or full policy surrender.

Only after the full value of premiums paid to date have been withdrawn are additional withdrawals taxable, as ordinary income. The notable exception to this rule involves modified endowment contracts (MECs), discussed below.

Example

Tim owns a universal life policy for which he pays an annual premium of $1,000. He has paid a total of $12,000 in premiums, and the policy has a $20,000 cash value.

If Tim makes a $10,000 withdrawal, he will avoid taxation because it is less than the sum of premiums paid.

A year later, the sum of premiums paid is $13,000. Were he then to make a $5,000 withdrawal, he would face an income tax liability on $2,000 of that amount. That is because he already used $10,000 of the premiums paid in offsetting the first withdrawal, and only $3,000 remains available to offset the $5,000 second withdrawal.

Income Taxation of Policy Dividends

Life insurance policy dividends are a return of excess premiums (called “divisible surplus”) and therefore are not taxable.

However, interest earned on dividends left with the insurer under the “accumulate at interest” dividend option is taxable in the year earned. The dividends themselves, when distributed, are tax free.

Income Taxation of Accelerated Benefits

In accordance with the Health Insurance Portability and Accountability Act (HIPAA), accelerated benefits paid to the insured are not taxable if the insured meets the definition of terminally ill or chronically ill. This applies to distributions from a viatical settlement as well as life insurance policy accelerated benefits provisions:

  • To be classified as terminally ill, the person must be certified by a doctor as having a condition that can be expected to result in death within 24 months.
  • To be classified as chronically ill, the person must have a mental or physical impairment that requires significant medical supervision.

Income Taxation of Endowment Contracts

An endowment contract pays a lump-sum death benefit at the insured’s death but also pays a lump-sum benefit if the insured is alive upon reaching a stipulated age (which often was age 65).

Endowment contracts purchased after 1986 no longer qualify as life insurance for tax purposes. The cash value does not enjoy tax-deferral status. Each year’s increase in the cash value is taxable income to the contract owner.

Endowment contracts issued before 1986 were grandfathered (meaning they are treated as life insurance for tax purposes) and some continue in force today.

Modified Endowment Contracts (MECs)

To receive the favorable tax benefits of life insurance, a policy must meet the Tax Code’s definition of life insurance. Included in this definition is the requirement that the policy not be “overfunded” so as to generate excessive cash values.

A policy that violates this rule is deemed a modified endowment contract (MEC) and loses the benefit of tax-free cash value distributions (whether through loans or withdrawals).

When a Life Insurance Policy Becomes a MEC: The 7-Pay Test

A policy becomes a MEC if it fails to meet the 7-pay test: If, at any point during the first seven policy years, the sum of premiums paid at that point exceeds the sum of premiums that would have been required at that point to pay up the policy in seven years, the policy becomes a MEC.

Once a policy becomes a MEC it can never revert to a non-MEC status.

Income Tax Treatment of MECs

Policies that are deemed MECs still enjoy two important tax advantages that apply to all life insurance policies, but only as long as the policy is used for the fundamental purpose of providing a death benefit:

  • The death benefit is income tax free when paid at the insured’s death.
  • The cash value grows tax deferred as long as it stays in the contract.

However, cash distributions from a MEC while the insured is alive are penalized. Policy dividends, cash value withdrawals, and policy loans are subject to income taxation as follows:

  • MEC withdrawals and policy loans are treated on a last-in/first-out (LIFO) basis. That is, they are considered first to be distributions of taxable interest earnings (the “last in”). Only after all taxable interest has been distributed are any future distributions deemed a nontaxable return of premiums.
  • Dividends received under a MEC, except dividends that are used to purchase paid-up additional insurance, are generally taxable as income.

In addition, distributions of earnings from a MEC taken before the owner's age 59½ are subject to a 10 percent premature distribution income tax penalty. The penalty is waived if the policyowner is disabled or if the withdrawal is taken in substantially equal periodic payments over the owner's life expectancy.

Key Point

Do not confuse a MEC with a traditional endowment contract. A MEC is not a unique type of life insurance but a classification assigned to any permanent life insurance policy that violates excessive funding rules of the Tax Code.

Taxation of Corporate-Owned Life Insurance

Corporate-owned life insurance (COLI) is any type of individual life insurance covering employees of all levels in which the corporation is both owner and beneficiary. Businesses are permitted to retain the policy even if a covered employee terminates employment.

Premiums paid by the business to fund a COLI policy are usually not tax deductible.

Written consent of every insured employee is required before the policy is issued; otherwise, death benefits are taxable to the business whenever paid. Obtaining consent after a COLI policy is issued will not reverse this taxable benefit status.

For Your Review

  • Except in certain transfer-for-value cases, life insurance death benefits are income tax free.
  • Settlement options that involve leaving death benefit proceeds with the insurer will result in taxation on the interest portion of future distributions.
  • The death benefit of any life insurance policy owned by the insured at death is included in that person's estate.
  • Policy cash values accumulate tax deferred and are tax free if distributed as part of the death benefit.
  • Non-MEC policy cash value distributions are taxed under favorable FIFO rules, meaning withdrawals are treated first as a tax-free return of premiums.
  • Life insurance policy dividends are a return by the insurer of excess premiums (called “divisible surplus”) and therefore are not taxable, but interest accrued on dividends left with the insurer is taxable.
  • Accelerated benefits paid to the insured are not taxable if certain qualifications are met.
  • A MEC is not a unique type of life insurance but a classification assigned to any permanent life insurance policy that violates excessive funding rules of the Tax Code. Once a policy becomes a MEC it can never revert to a non-MEC status.
  • Cash distributions from a MEC while the insured is alive are subject to unfavorable LIFO tax rules and therefore subject to income taxation. If the policyowner is under age 59½, a 10 percent penalty may also be assessed.