Federal Tax Considerations for Life Insurance and Annuities

Modified Endowment Contracts

(MECs) Following the elimination of many traditional tax shelters by the Tax Reform Act of 1984, single premium life insurance remained as one of the few financial producsts offering significant tax advantages. Offer tax-deferred growth and tax-free cash flow avail via policy loans and partial surrenders

Conditions where 10% penalty will not apply

-age 59 1/2 -totally disabled -$ used to make DP on a home, not to exceeed 100K, and for first time homebuyer -w/d used for post-secondary ed -used for catastrophic med expenses or upon death

Traditional IRA taxation rules

-tax deductible contributions for the year of the contribution (based on person's income) -Contributions must be made in cash (cash, check, money order) -tax-deferred earnnings are not taxed until withdrawn

3 situations that will result in life insurance being included in the insured's taxable estate

1. Incidents of ownership - If the policy owner used cash, changed beneficiary, policy loans, or the right to assign the policy, the entire face amount will be included in the insured's taxable estate

General tax rules to life insurance policies

1. Premiums are not tax deductible 2. Death benefit are tax free if taken as a lump-sum distribution to a named beneficiary 3. Death benefit paid in installments (other than lump sum): principal is tax free; interest is taxable

FIFO vs LIFO

FIFO - Life insurance Annuities follow LIFO

Withdrawl of Interest and Principal

When money is withdrawn from the annuity during the accumulation phase, amount are taxed on a LIFO. All withdrawls will be taxable until the owner's cost basis is reached.

Settlement options

When the beneficiary receives payments consisting of both principal and interest, the interest portion of the payments received is taxable as income.

Life insurance proceeds paid to a named beneficiary

are generally free of federal income taxation if taken as a lump sum. An exception would be if the benefit payment results from a transfer for value - ex sold to another party prior to the insured's death

Roth IRAs

contributions are not tax deductible excess contributions are subject to a 6% tax penalty

Seven pay test

established by the IRS, The culmulative premiums paid during the first 7 years of the policy must not exceed the total amount of net level premiums that would be requied to pay the policy up using guaranteed mortaliy costs and interests.

Distribution from an IRA

is subject to income taxation in the year the withdrawl is made. If prior to age 59 1/2, a 10% penalty will also apply

Section 1035 Exchanges

of the Internal Revenue Code, When a policy owner exchanges a cash value life insur policy for another cash value ife insur policy, or a cash value life policy for an annuity, or an annuity for an annuity, the policies or annuities must be on the same life. There will be no income tax on these transactions. The key is that the exchange may not be from a less tax-advantaged contract to a more tax advantaged contract.

Exclusion ratio

used to determine the annuity amounts to be excluded from taxes.

MEC vs Life Insurance

All life insur policies are subject to the 7 pay test and any time there is a material change to the policy (any increase in the death benefit), a new 7 pay test is required. Any policy that fails, is classified as MEC and loses the standard tax benefits.

Dividends

Dividends are returned premiums, therefore not taxable. When dividends are left with the insurer to accumulate interest, the interest earned on the dividend is subject to taxation as ordinary income each year interest is earned.

Distributions at Death

If the contract holder dies before annuitizaton date, the contract's interest is taxable. If the beneficiary is a spouse, the tax can continue to be deferred.

Values Included in the Annuitant's estate

If the deceased annuitant paid all the premiums, the value of the annuity benefits is includable in the gross estate of the deceased annuitnat. If annuitant died during accumulation, then only the amt of premiums paid into the annuity will be included in their gross estate.

Taxation of IRAs

When an annuity is used to fund a traditional IRA, distributions are fully taxable if contributions were made with pretax dollars. If there are no distributions at the required age, or if the distributions are not large enough, the penalty is 50% of the shortball from the required annual amount.

Corporate-owned

-growth is not tax deferred -interest income is taxed annually unless the corporation owns a group annuity for its employees and each employee receives a certificate of participation

Estate as beneficiary

If the insured's estate is the designated beneficiary at the time of the insured's death, the entire face amount of the policy will be included in his or her taxable estate.

Transfer of ownership

If the insured, as policyowner transfers ownership of the policy or makes it a gift within 3 years prior to his or her death, the entire face amount will be included in his/her taxable estate.

Traditional IRA-Amounts received by beneficiary

If the owner dies before distributions have begun, the entire interest must be distributed in full on or before Dec 31 of the cal year that contains the 55th anniversay of the owner's death, unless the owner has named a beneficiary. payouts must begin by 70 1/2

Policy loans

Money borrowed against the cash value is not income taxable; the insurancce company charges interest on outstanding policy loans. Policy loans, with interest can be repaid in the following ways: -by the owner while the policy is in force -at policy surrender or maturity - subtracted from the cash value -at the insured's death - subtracted from the death benefit

Individually owned (taxation of annuities)

Principal paid-in is not taxable (cost base) Interest earned on the principal is taxable (tax base)

Distributions

Taxation rules to MEC's cash value: -tax deferred accumulatons -Any distributions are taxable, w/d and loans -Distributions are taxed on LIFO - "interest-first" rule -Distributions before age 59 1/2 are subject to a 10% penalty -

Tax-deferred accumulation

The interest accumulated in any annuity is the tax base, but the taxes are deferred during the accumulation period.

2 most common qualified individual retirement plans

Traditional IRA Roth IRA Anybody with earned income may contribute to these plans

Cash Value Increases

Upon surrender or endowment, any cash value in excess of cost basis (premium payments) is txable as ordinary income. Death benefits are generally paid to the beneficiary income tax free.

Surrenders

When a policyowner surrenders a policy for cash value, some of the cash value received may be taxable as income if the cash surrender value exceeds the amount of the preiums paid for the policy

Rollovers and transfers

rollover is a tax-free distribution of cash from one retirement acct to another; completed within 60 days from the time taken out of one plan; If distribution is paid diretly to the participant, 20% of the distribution must be withheld by the payor. The 20% withholding of funds can be avoided if the distribution is made directly from the first plan to the trustee or administrator/custodian of the new IRA plan (direct rollover) Transfer (or direct transfer) refers to a tax free transfer of funds from one retirement program to a traditional IRA or a transfer of interest in a traditional IRA from one trustee directly to another.