Chapter 7 - Taxation of personal life insurance

Group Life Insurance - Premiums Paid by the Employee

Any employee paid premiums are not eligible for a tax deduction. Death benefit proceeds from a group life insurance plan to an employee's named beneficiary are received income tax free.

Death Benefit proceed

Are generally not considered taxable income when paid in one lump sum. If a settlement option is chosen any interest or earnings component of each payment is taxable as ordinary income.

Premium Taxation

Considered a personal expense and are not deductible.

Cost Basis

Cost basis is the amount of premium paid into the policy thus far...not taxable...only taxable if a loan is taken out higher than the premiums paid

Tax Advantages for Employees

Employee contributions are either pretax or tax deductible.

Group Life Insurance - Premiums Paid by the Employer

Group Term Life premiums paid by an employer are tax deductible to the business as an ordinary and necessary business expense. 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.

MEC Taxation

If a contract is deemed to be a MEC, 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. This means that all withdrawals taken from the policy will be considered earnings and taxed as ordinary income. Once the amount withdrawn equals the amount of earnings, future withdrawals are considered part of the cost basis and are paid income-tax free.

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 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. Interest paid on a policy loan is not tax-deductible.

MEC 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 Funds are subject to a 10% penalty on gains withdrawn prior to age 59 ½. This is considered a premature distribution. Distributions made on or after 59 ½ and distributions paid out due to death or disability are not subject to the penalty.

ERISA qualified plans

Must benefit employees and beneficiaries May not discriminate in favor of highly compensated employees Must be approved by the IRS Have a vesting requirement

Cash Values

Not taxable at the time credited to the policy. Gets taxed when the policy is surrendered, sold, transferred or matures.

Types of Qualified Plans

1) Savings Incentive Match Plan for Employees (SIMPLE) 2) Simplified Employee Pensions (SEPs) 3) Self-Employed Plans (HR-10 or KEOGH Plans) 4) 401K Plan 5) Tax-Sheltered Annuities (TSAs)

Savings Incentive Match Plan for Employees (SIMPLE)

A SIMPLE plan may be established either as an IRA or a 401(k) plan. The employer's contribution must be immediately vested at 100%. This means that the employee is entitled to all the employers' contributions immediately. Only available to companies that have fewer than 100 employees and must be the only type of plan the company has available for the employees. An advantage of a SIMPLE plan is the elimination of high administrative costs.

Tax Advantages for Employers

Qualified plans receive favorable tax treatment. Employer contributions are immediately tax deductible to the employer at the time the contribution is made (These contributions are not taxable to the employee until withdrawn)

7-Pay Test

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-year Pay Whole Life policy providing the same death benefit.

Cost recovery rule

The amount of withdrawals up to the policy's cost basis will not be taxable. Any withdrawals in excess of the cost basis will be taxed as ordinary income.

Dividends

The dividends themselves 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. When the dividend received exceeds the total premium paid for the life insurance policy, the excess dividends are then considered taxable income.

Estate Taxes and Benefits Included

The policyowner may name the estate as a beneficiary, or by default, if no beneficiary is living at the time of the insured's death, the benefit will automatically be paid into the insured's estate. These values will be added to the amount in the estate and potentially be subject to federal estate taxes. If the policyowner is also the named insured, the proceeds will be added to the value of the insured's estate.

Modified Endowment Contract (MEC)

Under current law, if a policy is overfunded in the early years (funded too quickly) it will be classified as a Modified Endowment Contract (MEC). ex: single premium life, universal and variable universal the the flexible premium feature allows the owner to pay premiums on their one scale. 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.

ERISA (Employee Retirement Income Security Act)

a federal law that sets minimum standards for pension plans in private industry. ERISA does not require any employer to establish a pension plan. It only requires that those who establish plans must meet certain minimum standards.

Tax-Sheltered Annuities (TSAs)

are qualified annuity plans benefiting employees of public schools under the Internal Revenue Code (IRC) Section 403(b), as well as other nonprofit organizations qualified under Section 501(c)(3). Employees of nonprofit organizations may have an arrangement with the employer whereby the employer agrees with each participating employee to reduce the employee's pay by a specified amount and invest it in a retirement fund or contract for the employee. Employees do not make direct payments to the retirement fund.

Self-Employed Plans (HR-10 or KEOGH Plans)

available to unincorporated sole proprietors and their eligible employees. (Silent partners are not eligible) Contributions for eligible employees are mandatory and based on the percentage of contribution made by the employer for his or her own account. These contributions are deductible.

401(k) Plans

is a defined contribution plan for employees or profit sharing plan of for-profit companies. defined contribution plan: employees define their contribution as a percentage of income or a fixed dollar amount per payroll period. The employer must deduct that amount from pay and forward to the plan custodian on a timely basis. Participants typically invest in a portfolio of mutual funds. Profit sharing plan: The employer defines the circumstances under which profit-based contributions will be made, and contributions must generally be made in at least 3 out of 5 consecutive years

Nonqualified Plans

not required to meet ERISA requirements and are not eligible for the same favorable tax treatment. do not have vesting requirements and in many cases are not funded by the employer until the employee actually retires. It is possible that the employee may lose retirement benefits if the employer goes out of business

Simplified Employee Pensions (SEPs)

set up by any private sector company that does not offer another type of qualified plan. This plan is very popular with self-employed individuals. The SEP plan uses employer-funded IRAs. The employer makes contributions and deducts the payments as a business expense. All distributions to employees are taxable upon receipt.

Accelerated Death Benefits

tax free to a recipient if the benefit payment is qualified. To be a qualified benefit, it must meet the following conditions: 1) A physician must give a prognosis of 24 months or less life expectancy for the named insured 2) The amount of the benefit must at least be equal to the present value of the reduced death benefit remaining after payment of the accelerated benefit 3) The insurer provides a monthly report for the insured showing the amount paid and the amount of benefit remaining in the life insurance policy