chap 7

Cash Values

A cash value policy may experience increases in the cash value annually. Part is from the premium and part is from any interest or gains. The interest or gains are not taxable at the time they are credited to the policy. Any earnings in the cash value are allowed to grow on a tax-deferred basis until one of the following events occurs: The policy is surrendered The policy is transferred for value (e.g. sold or assigned) The policy ceases to meet the IRS definition of a life insurance contract If the policyowner does sell, surrender, or withdraw funds from the policy, the difference between what is received and what had been paid in is taxed as ordinary income. This is the Cost Recovery Rule. When withdrawing cash from a cash value life insurance policy, the amount of withdrawals up to the policy's cost basis will be tax free. This is referred to as First In, First Out, or FIFO. The cost basis is the amount of premiums paid into the policy less any dividends or withdrawals previously taken. Any withdrawals in excess of the cost basis will be taxed as ordinary income. Upon surrendering a cash value life insurance policy, any gains will be subject to federal, and possibly state, income tax. The gain on the surrender of a cash value policy is the difference between the gross cash value paid out, plus any loans outstanding, and the cost basis in the policy. If the policy matures, the cash value will be paid as a lump sum. As with other distributions made while the insured is alive, the sum in excess of the cost basis is taxable as ordinary income.

Death Benefit Proceeds

Death benefit proceeds from a group life insurance plan to an employee's named beneficiary are received income tax free.

Accelerated Death Benefits

The payment of an accelerated death benefit is tax free to a recipient if the benefit payment is qualified. To be a qualified benefit, the benefit must meet the following conditions: A physician must give a prognosis of 24 months or less life expectancy for the named insured. The amount of the death benefit must at least be equal to the balance of the face amount remaining after payment of the accelerated benefit. The total amount of payout cannot be less than 100% of the original face amount. The insurer provides a monthly report for the insured showing the amount paid and the amount of benefit remaining in the life insurance policy.

Life Insurance Transfer for Value Rule

The transfer-for-value rule was passed by Congress to discourage business transfers of ownership between parties looking to take advantage of the tax free status of life insurance death benefits. If a life insurance policy is transferred to a new owner in return for any kind of material consideration, the transfer-for-value rule may result in the death benefit being partially or fully taxable at the time it is paid. The rule states that the amount of the death benefit that exceeds the value of consideration and any additional premium paid will be taxed as ordinary income. Example: A $500,000 policy is transferred to a new owner and sold for $50,000. After the sale the new owner pays $10,000 in life insurance premiums while the insured is alive. Upon death of the insured $60,000 ($50,000 + $10,000) of the death benefit is received income tax free to the beneficiary while $440,000 is taxable ($500,000 - $60,000).

Estate Taxes and Considerations

When an individual life insurance policy is owned by the insured, the value of the death benefit may be included in the insured's estate, either intentionally or by default. The policyowner may name the estate as a beneficiary. These values will be added to the amount in the estate and potentially be subject to federal estate taxes.

Dividends

A participating policy's dividend consists of the amount of premium that is returned to the policyowner if the insurance company achieves lower mortality and expense costs than expected. Dividends are paid out of the insurer's surplus for that year. The dividends are not taxable since dividends are considered a return of unearned premium. When dividends: Are left on deposit with the insurance company, interest earned on dividends is taxable as ordinary income in the year earned Received exceed the total premium paid for the life insurance policy, the excess dividends are then considered taxable income

Modified Endowment Contracts (MECs)

Prior to 1988, individuals could place large sums of money into a cash value policy (typically in a lump sum) and the cash would grow tax deferred until the insured died at which point a death benefit paid income tax free. Or if they needed cash, they could take a tax free lifetime loan. These policies were used to avoid paying taxes. Under current law, if a policy is funded too quickly it will be classified as a Modified Endowment Contract (MEC). MEC rules impose stiff penalties to eliminate the use of life insurance as a short term savings vehicle.

Premiums

For individuals, premiums are considered a personal expense and are not deductible. They are paid with after-tax dollars. This establishes a cost basis in the policy for tax purposes.

Taxation of Group Life Insurance Premiums Paid by the Employer and the Employee

Group term life premiums paid by an employer are tax deductible to the business as an ordinary and necessary business expense. Any employee paid premiums are not eligible for a tax deduction. Employer paid premiums in connection with group life insurance do not constitute taxable income to the employee unless the death benefit paid for by the employer exceeds $50,000. All employer paid premiums for amounts above $50,000 are reported as taxable income to the employee.

Taxation

If a contract is deemed to be a MEC, then any funds that are distributed are subject to a "last-in, first-out" (LIFO) tax treatment, rather than the normal "first-in, first-out" tax treatment. Taxable distributions include partial withdrawals, cash value surrenders and policy loans (including automatic premium loans).

Policy Loans

If a policyowner takes out a loan against the cash value of a life insurance policy, the amount of the loan is not currently taxable. This is true even if the loan is larger than the amount of the premiums paid in. The loan is not taxed as long as the policy is in force. If the policy lapses with a loan outstanding, the excess over cost basis becomes taxable as ordinary income. The interest paid on a permanent life insurance policy loan is not tax-deductible.

Penalties

If the contract is a MEC, all cash value transactions are SUBJECT TO TAXATION and penalty. Funds are subject to a 10% penalty on gains withdrawn prior to age 59½. This is considered a premature distribution. Distributions made on or after 59½ and distributions paid out due to death or disability are not subject to the penalty.

section 1035

Internal Revenue Code Section 1035 allows for the exchange of existing insurance policies into another without incurring any tax liability on the interest and/or investment gains in the current contract. These tax-free exchanges, known as 1035 exchanges, can be useful if another insurance policy has features and benefits that are preferred or are superior to those found in an existing contract. Policyowners must be aware that surrender charges might still apply on the existing contract, and a new surrender charge period may start after the exchange on the newly acquired policy. Further, the new insurance contract may have higher fees and charges than the old one which will reduce the returns or increase costs for such things as policy loans. Types of exchanges the IRS will allow on a tax-free basis are from: Life insurance to life insurance Life insurance to an annuity Annuity to an annuity Life insurance or annuity to long-term care But NEVER an annuity to life insurance When moving from an existing life insurance policy to a new life insurance policy as part of a 1035 exchange, the new life insurance policy will be issued only after a new application for coverage is received and the policy is issued and accepted.

Death Benefit Proceeds (Claims)

The death benefit, or face amount, of the policy is generally not considered taxable income when paid as a lump sum to a named beneficiary. If a settlement option is used instead of a lump sum payment, any interest or earnings component of each payment would be taxable as ordinary income.

7-Pay Test

When a contract does not pass the 7-pay test, it will be deemed a MEC. The 7-pay test is a limitation on the total amount that can be paid into a policy in the first 7 years. It compares premiums paid for the policy during the first 7 years with the net level premiums that would have been paid on a 7-pay whole life policy providing the same death benefit. As long as the policy premium guidelines are met, the policy will avoid being deemed a modified endowment contract. If a policyowner pays premiums in excess of the guidelines, the excess premium can be refunded by the insurer within 60 days after the end of the contract year. Since a single premium life insurance policy clearly does not pass the 7-pay test, it will automatically be deemed a MEC. The other types of policies that could be classified as MECs are flexible premium policies such as Universal and Variable universal life. The flexible premium feature allows the owner to pay premiums on their own schedule. Once a policy is classified as a MEC, it will maintain that classification for the life of the policy. The overfunding cannot be undone in future years.