Federal Tax Considerations for Life Insurance and Annuities

Amounts available to Policyowner

* Cash Value * Divisible Surplus * Policy Loans * Surrenders * Accelerated Benefits

Social Security Benefits & Taxation

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Social Security

Also known as Old Age, Survivors, and Disability Insurance (OASDI), was signed into law in 1935 by President Roosevelt as part of the Social Security Act.

Federal Estate Tax

Estates exceeding certain amounts are subject to federal estate taxes. The face amount of a life insurance policy may be included in the taxable estate of the deceased and subject to federal estate tax under a number situations.

Life Insurance as Gift

If a person gives a life insurance policy and all incidents of ownership as a gift, it may be taxable at the current replacement or cash value up to the amounts exceeding the federal gift limits. Individuals may also make a gift of a life insurance policy by paying premiums. The premium payments are taxable only up to those amounts exceeding the federal gift limits.

Non-Living Entity Owned Annuities

Interest earned on corporate-owned annuities are taxed on a current basis. The annuitant must be a human in order for the interest to be tax-deferred.

Modified Endowment Contracts

Over-funded life insurance policies in which proceeds are subject to taxation.

Taxation of Group Life Insurance

Premiums for group life insurance paid by the employee are not tax-deductible, but the employer can deduct premiums it pays as a business expense. Proceeds from a group life policy are tax-free if taken in a lump-sum. Proceeds taken in installments will be subject to taxes on the interest portion of the installments.

Seven-pay Test

Premiums paid cannot cause a policy to be paid-up after seven years. Used to determine if a Life Insurance policy as actually a MEC.

Accelerated Benefits

Received income tax-free as long as the distribution is qualified, meaning that the insured is suffering a terminal illness which is expected to result in death within two years.

Maximum Family Benefit

The maximum monthly amount a covered worker and his family can receive from Social Security.

Divisible Surplus Funds

The result of the overpayment of premiums and are distributed to policyholders through the issuance of dividends. Because these dividends are considered a return of overcharged premium, they are considered not taxable because premiums are paid with after-tax dollars. Interest earned on dividends is taxable income.

Exclusion Ratio

Used to determine which portion of the annuity payment is taxable (i.e. interest earned vs. premium or cost basis).

Dual Benefit Eligibility

A person who is eligible for multiple Social Security benefits, such as survivors and retirement.

Fully Insured

A person who is fully insured is entitled to full Social Security benefits. To obtain fully insured status, a covered worker must accrue one quarter of coverage each calendar year after the age of 21 for a total of 40 quarters (about 10 years of work) and a minimum of six quarters.

Social Security Payroll Tax

For employees in 2013 is 6.2%. Employers must pay a matching 6.2% Social Security tax. Self-employed individuals pay both taxes for a total of 12.4%. Currently capped at $110,100 and indexed each year.

Amounts Received by Beneficiary

Generally, beneficiaries receive life insurance proceeds tax-free if received in a lump-sum; however, the proceeds may be subject to state income tax.

Medicare Part A Payroll Tax

Tax of 1.45% must be paid by both employees and employers. Self-employed individuals must pay the entire 2.9% Medicare Part A tax. There is no cap.

Currently Insured

A currently insured person is only entitled to partial Social Security benefits. To obtain currently insured status, a covered worker must accrue at least six quarters of coverage over the past 13 quarters ending with the quarter in which the covered worker.

Transfer for Value Rule

Life insurance proceeds are subject to taxation if they result from a transfer for value, or sale of the policy to a third party. A transfer of value constitutes any exchange of the policy benefits for something of value, whether it be money, an exchange of policies, or consideration for another contract. Does not apply to assignment of benefits for collateral on a loan or transfer between the policyholder and the insured.

Section 1035 Exchanges

Section 1035 of the Internal Revenue Code allows for certain exchanges without recognizing a gain or loss for tax purposes (e.g. annuity for annuity, endowment for endowment, etc.)

Surrenders

Upon policy surrender, cash value greater than the amount of premiums paid is subject to tax. For example, a whole life insurance policy is surrendered with a total cash value $200,000; however, the owner has only paid $110,000 of premiums. The $90,000 is taxable.