Social Security and Tax

Social Security

(also referred to as OASDI—old age, survivors, and disability insurance) benefits are determined by a formula based on earnings. Nearly 90% of all employed persons are covered by Social Security and pay Social Security taxes. Employees pay 50% of the employment tax. Selfemployed persons pay 100% of the tax. The Social Security Administration is responsible for administering benefits and collecting premiums. To receive most Social Security benefits, a person must be fully insured. A few of the survivor benefits are payable for currently insured persons.

Insured Status

A covered worker becomes qualified for Social Security benefits by attaining either fully, currently, or disability insured status. Insured status depends on how many quarters of coverage a worker has earned.

Disability Insured

A special insured status is required if a worker is eligible for disability benefits under Social Security. This status requires that the worker be fully insured and have earned at least 20 quarters of coverage in the 40 calendar quarter periods ending with the calendar quarter in which the disability begins. This requirement is modified slightly if a covered worker is disabled before age 31. The individual's insured status determines eligibility for Social Security benefits. A fully insured person and eligible dependents are entitled to all Social Security benefits. A worker who is only currently insured has limited benefits available. If a worker is only currently insured at death, Social Security benefits would be payable only to a dependent child in addition to the lump-sum death benefit of $255.

fully insured

A worker who has worked 40 quarters

Accelerated Benefits

Accelerated, or living, benefits paid by a life insurance policy fall into the same category as a policy's death benefits—that is, accelerated benefits are received income tax free as long as they are qualified. Other stipulations may be applied, but the end result is that those who require access to these benefits may receive the money without having to pay income taxes on it.

surrendered or matured life insurance policy

Generally speaking, when any proceeds are received from a surrendered or matured life insurance policy, the part of the proceeds, if any, that exceeds the cost of the policy is subject to ordinary federal income tax in the year received. Cost is equal to the total premiums paid (not including costs for qualified additional benefits) less the sum of any amounts previously received under the contract that were not includable in gross income. Suppose Olaf surrenders his whole life policy, and it has a cash value of $25,000. During the time he held the policy, Olaf paid $22,000 in premiums. As a result, $3,000 ($25,000 less $22,000) of the cash surrender value will be subject to federal income tax.

Annuity Payments

Like income payments made as a result of a settlement option in a life insurance policy, income payments made from an annuity are only partly subject to federal income taxation. Federal tax law holds that a fixed part of each annuity income payment is designated as a return of capital and as such is nontaxable. The remainder of each annuity income payment is considered to be income and is taxable.

Dual Benefit Liability

Often a person is eligible to receive more than one Social Security benefit. For example, a spouse who has reached age 65 may be eligible to receive a retirement benefit based on her own earnings and also a benefit based on her late husband's earnings. In these cases, the person is entitled to receive only the larger of the two benefit amounts instead of both amounts.

Primary Insurance Amount

Social Security benefits are expressed as a percentage of the primary insurance amount (PIA). The PIA for a worker is based on the average level of earnings of that worker and is updated and published annually in tables by the federal government. Most types of Social Security benefits are some percentage of the PIA as set for the year for the worker's earnings level.

Social Security Taxes

Social Security is a pay-as-you-go program—that is, the Social Security taxes collected from workers are not set aside in an account for each worker but are used to pay benefits to current beneficiaries of the program. Put another way, when someone begins receiving benefits, she is not drawing on a fund of some specific amount that consists of her previous tax deposits plus earnings. Those benefits are financed by the taxes currently collected from covered workers. Social Security benefits are financed by a payroll tax on employers, employees, and the self-employed. There is no Social Security tax on investment income (e.g., interest or dividends) or any kind of income other than earnings from employment or self-employment. The rate of tax is a flat amount set by Congress and adjusted upward from time to time. The tax rate for employers and employees is currently set at 6.2% (not counting the additional tax for Medicare). The self-employment tax rate is 12.4%—twice the employee rate—because self-employed individuals pay both the employee and the employer portion of the tax. The tax rate is multiplied by the relevant earnings figure to compute the Social Security tax.

Surviving spouse's benefit

The eligible surviving spouse of a fully insured worker is entitled, at the spouse's normal retirement age, to a monthly life income equal to the worker's primary insurance amount (PIA) at death. Or, if the spouse wishes to receive these benefits early, the spouse can elect reduced benefits, starting as early as age 60. If the surviving spouse has a dependent child, and the child was a dependent of the deceased worker, an additional benefit of 75% of the worker's PIA is payable, regardless of the spouse's age, until the child reaches age 16. Disabled children will entitle the surviving spouse to this benefit indefinitely, as long as the child remains disabled and under the care of the surviving spouse.

Business Insurance

The premiums paid by companies for life insurance policies used for business purposes are generally not deductible as business expenses, with the exception of group insurance. By the same token, the proceeds from life policies purchased for business purposes are received by the company income tax free. Policy proceeds are usually not includable in the estate of an individual insured by a business unless the individual possessed some incident of ownership in the policy. This is true even if the insured was the owner or one of the owners of the business.

Maximum Family Benefit

When several members of a worker's family are entitled to receive benefits, the family may run up against an overall limitation on benefit payments called the maximum family benefit. Like the PIA, a maximum family benefit is established for each level of average earnings and is updated annually.

Policies that do qualify as a 1035(a) exchange are:

a cash value life insurance policy to another cash value life insurance policy; a cash value life insurance policy to an annuity; and an annuity to another annuity.

Life insurance proceeds

may or may not be subject to federal income taxes and/or estate taxes

A person is fully insured if:

that person has at least six quarters of coverage; and that person has acquired at least as many quarters of coverage as there are years elapsing after 1950 (or, if later, after the year in which the person reaches age 21) and before the year in which that person dies, becomes disabled, or reaches, or will reach age 62, whichever occurs first.

Fully Insured

A person becomes fully insured by acquiring a sufficient number of quarters of coverage to meet either of the following two tests: A person is fully insured after acquiring 40 quarters of coverage (10 years of covered employment). Once a person has acquired 40 quarters of coverage, that person is fully insured for life, even if that person spends no further time in covered employment (or covered self-employment).

Currently Insured

A person is currently insured after acquiring at least six quarters of coverage during the full 13-quarter period ending with the calendar quarter in which the person: died; most recently became entitled to disability benefits; or became entitled to retirement benefits.

Taxation of Social Security Benefits

A portion (up to 85%) of the Social Security retirement income benefit is includable in the worker's adjusted gross income for tax purposes. Various formulas apply depending on the level of adjusted gross income, whether the taxpayer is married or single, and if married, whether filing separate or joint returns.

Gifts of Life Insurance

Anyone who makes a gift of a large amount may have to pay a gift tax. Probably the most common method of making a gift of life insurance to someone other than a charity is literally to give a policy to the donee. If this gift involves the transfer of all the incidents of ownership from the donor to the donee, the gift will probably qualify for a present interest gift tax exclusion, and the donor will not incur gift tax liability. This is true unless the replacement value of the policy, which is usually about equal to the cash value, is more than a certain threshold ($13,000 in 2010 or $26,000 for a joint/split gift by a donor and spouse). The second most common method of making a gift of life insurance is to make a gift of the premiums on the insurance. As long as the amount of premium paid by the donor, plus all other gifts made during the same year to the same donee, is equal to or less than the annual gift tax exclusion, the donor should not incur federal gift tax liability. A donor (or donors) may continue to make a tax-free gift of insurance premiums of up to $13,000 ($26,000 for donor and spouse) each year as long as desired. The recipient of the gift does not have to pay income tax on the gift.

Retirement Benefits

By working and paying Social Security taxes, individuals earn "credits" toward Social Security benefits. Benefit payments are based on how much was earned over a full working career. Higher lifetime earnings result in higher benefits. Benefit payments are also affected by the age at which you retire. The "full retirement age" is 65 for people who were born before 1938. But because of longer life expectancies, the Social Security law was changed to gradually increase the full retirement age until it reaches age 67. This change affects people born in 1938 and later.

Disability Benefits

Disability under Social Security has a five-month elimination period and is defined as "the inability to engage in any substantially gainful activity by reason of medically determinable physical or mental impairment that can be expected to result in death or that has continued or can be expected to continue for at least 12 full months."

Dividends

Dividends paid to participating policyowners are generally not taxable as income. They are considered a return of premium. However, any interest earned on dividends is taxable, so the accumulation at interest dividend option explained earlier would incur income tax liability for the interest earned on the accumulated dividends. Any dividend of an MEC that the insurer keeps to pay principal or interest on a policy loan is, just like the loan itself, considered to be money taken from the policy.

Cash surrender value

If a policyowner surrenders a policy for its cash value, some of the cash value received may be subject to ordinary income tax if it exceeds the sum of the premiums paid for the policy. Generally, the amount equal to premium payments is not taxable. Any additional amount in excess of the premium payments made would be taxable as income.

Transfer for Value Rules

Lump sum life insurance proceeds may not be exempt from income taxes if the benefit payment results from a transfer for value. If the benefits were transferred to a person in exchange for valuable consideration (such as money, services, or something else of value), the proceeds would be taxable as income. This section of the tax laws is designed to prevent a tax exemption for benefits that are purchased from another party because the intent of the transaction would be to exchange something of value for tax free income. Any profit received by the investor would be taxable as income. Exceptions to the transfer of value rule include an assignment of benefits as collateral security, transfers between a policyholder and an insured, and transfers to a partner or a corporation of the insured.

Social Security provides the following categories of benefits:

Monthly retirement benefits for retired workers at least age 62, Monthly benefits for spouses of retired workers, Monthly survivor benefits for the spouse and certain other survivors of deceased workers, Monthly disability benefits for disabled workers and their dependents, A modest lump-sum death benefit payable at a worker's death

Eligibility for Social Security

Most workers are covered under Social Security, including common-law employers and employees, most self-employed persons, Armed Forces personnel, and employees of nonprofit organizations. The main excluded worker groups are railroad workers and federal employees hired before 1984. Federal employees hired after 1984 are covered. Railroad workers contribute to their own railroad retirement system. In addition, employees of state and local governments are not covered unless the government entity has entered into an agreement with the Social Security Administration or does not have a retirement program.

Retirement Earnings Limit

Once a Social Security retiree reaches normal retirement age, there is no restriction on the amount the retiree may earn from employment (or selfemployment) without losing Social Security benefits. Retirees age 64 and under may earn only up to a certain amount without a reduction in benefits. One earnings limit applies to retirees who have not yet reached their normal retirement age, and a modified limit applies in the year an individual reaches normal retirement age. The dollar amounts are indexed to inflation and change annually. For 2010, for example, a retiree who has not yet reached normal retirement age would face a reduction in retirement benefits of $1 for every $2 earned beyond $14,160. In the year an individual reaches normal retirement age, $1 in benefits will be deducted for every $3 earned in excess of $37,680 (the limit for 2010).

Cash Value Accumulation

One of the most significant advantages of life insurance products is their ability to accumulate cash on a tax-deferred basis. Permanent life products, including variable and universal life products, may accumulate cash values that are not taxed unless and until withdrawn. The same is true of annuities, qualified retirement plans, and IRAs. All of a policyholder's current earnings are working for the policyholder, unreduced by a current tax liability. Note, however, that annuities owned by corporations, for whatever purpose, do not accumulate cash on a tax-deferred basis. Bank accounts, stocks and bonds, and other kinds of noninsurance investments pay interest or dividends that are taxed currently.

Policy loans

Policy loans under life insurance policies are not taxable as income because they are treated as a debt against the policy. Under contract terms, policy loans must be paid back with interest in order to maintain policy values. Otherwise, outstanding loans reduce any available death benefit.

Premiums

Premiums paid for individual life insurance are considered to be a personal expense and are not tax deductible. When a business buys group term life insurance for its employees, premiums are generally considered a necessary business expense and are tax deductible. However, when a business buys life insurance to perpetuate the business (for example, under a buy-sell agreement), the premiums are considered to be a capital investment and are not tax deductible.

Group Life Insurance

Proceeds from a group life policy, like those from an individual life policy, are not subject to federal income tax when received by the beneficiary as a lump-sum payment. Premiums for group life insurance policies, whether paid by the employer entirely or shared by employer and employee, are not deductible by the employee, but a company can deduct such premium payments as a business expense. When all or part of the premiums for group life insurance are paid by the employer, these contributions are generally not considered as income to the employees covered by the group life policy. However, this rule applies only to the first $50,000 of employer-provided coverage. The cost of coverage in excess of $50,000 will be taxed to the employee.

Charitable Uses of Life Insurance

There are two basic ways to make charitable gifts of life insurance. The first is to make an outright gift of a policy on the life of the donor. The value of the policy at the time of the gift is generally deductible, with certain restrictions. The charity (the donee) is the beneficiary. The donor may give the charity enough cash each year to pay the premium on the policy; if so, the cash gifts are generally deductible. When this method of giving is used, it is important that the donee, the charity, be given all the rights of ownership. If the donor retains any control over the policy, the tax advantages (deductions) are lost. In the second method, the donor can retain ownership of the policy, make the charity the beneficiary, and continue to pay the premiums. In this case, the premium payments are not tax deductible. The amount of the proceeds will be included in the donor's estate but will wash out as a charitable deduction. One advantage of this method is that the donor retains the right to change beneficiaries if this becomes necessary or desirable. The principal disadvantage is that premium payments are not deductible.

Lump-sum death benefit

This benefit helps the deceased's survivors to pay for funeral costs. The lump-sum death benefit provided by Social Security may not exceed $255. Payment is made to a surviving spouse who was living with the deceased. If no surviving spouse is present, the benefit may be paid to an eligible child.

Doctrine of Economic Benefit

This rule holds that if an employee receives property or benefit in lieu of income and that property or benefit would have been taxable income if it were received in cash, an economic benefit has been received and will be taxed accordingly. Non-qualified plans, such as deferred compensation, that are funded with life insurance and aimed at certain key and/or highly compensated employees, may be affected by this rule. Qualified plans containing insurance on the life of the plan participant also may be affected. Care must be taken if those employees are to escape current taxation on such plans.

Modified Endowment Contract

To discourage the use of life insurance contracts with high premiums as investments, federal law subjects all permanent policies to a test. A life insurance policy that fails the test will be considered a modified endowment contract (MEC), which makes the policy subject to less favorable tax treatment. A policy that passes the seven-pay test is not an MEC. Before this test, single premium life policies and other types of limited-pay contracts were taxed the same as other life insurance policies. A policyowner was able to borrow (make withdrawals, and so forth) from the policy's cash value without paying tax. A modified endowment contract is a life insurance policy with premiums that exceed what would have been paid to fund a similar type of life insurance policy with seven annual premiums (the seven-pay test). For example, if the total aggregate premiums paid at any time during the policy's initial seven years exceed the total premium that would have been paid on a seven-year level annual premium basis for the same period, the contract will not meet the required seven-pay test and will be considered a modified endowment contract. Modified endowment contract tax treatment makes the utilization of a high premium life policy as a short term investment less attractive because it will be more costly. Funds withdrawn are subject to last-in first-out (LIFO) tax treatment, which assumes that the investment or earnings portion of the contract's values is withdrawn first (making these funds fully taxable as ordinary income) before the insured's basis (the total amount of premiums paid; the insured's basis in the con tract is always returned without being subject to income taxation). In addition to paying income tax on withdrawn amounts, a penalty of 10% is imposed on the total withdrawals, basis, and growth made prior to age 59½. Because it is more costly, the return on investment experienced by an MEC policyowner will be less. Like an annuity, the cash value buildup accumulates tax free unless it is withdrawn. Once a policy is classified as a modified endowment contract, it will remain an MEC forever, and it will also automatically make any policy subsequently received in exchange for it a modified endowment contract, even if the new policy would otherwise pass the seven-pay test.

Normal Retirement Age

To receive full Social Security retirement benefits, a person must wait until normal retirement age. If benefits are taken before this age, the monthly benefit amount is reduced. The Social Security normal retirement age is currently 65. It will gradually increase to age 67

Section 1035 (Policy Exchanges)

Under Section 1035(a) of the Internal Revenue Code, certain exchanges of insurance policies and annuities may occur as nontaxable exchanges. Generally, if a policyowner exchanges a life insurance policy for another life policy with the same insured and beneficiary and a gain is realized, it will not be taxed as income under section 1035(a).

Individual Life Insurance

Values included in the insured estate. With respect to federal estate taxes, life insurance proceeds are subject to inclusion in the deceased's estate for federal estate tax purposes if any of the following apply: The estate was the named beneficiary. The deceased was the policyowner. The deceased transferred the policy to another person within three years of death. In contrast, many individually owned life insurance policies could be subject to estate taxes because the insured is often the policyowner. However, agents should be aware that because of the federal "unified tax credit," estate taxes should only be a concern for those with significant assets.

Social Security survivors benefits can be paid to:

a widow or widower; a disabled widow or widower—as early as age 50; a widow or widower at any age if that person takes care of the deceased's child who is under age 16 or disabled and receiving Social Security benefits; unmarried children under 18 or up to age 19 if they are attending high school full time; stepchildren, grandchildren, or adopted children under certain circumstances; children at any age who were disabled before age 22 and remain disabled; or dependent parents age 62 or older.

Lump sum settlements

are not taxable as income. This is true whether the policy is an individually owned contract or a business owned policy. Thus, an individual or corporate beneficiary pays no federal income tax on life insurance proceeds.

Installment payments

are partially taxable as income. Whenever life insurance proceeds are taken other than in a lump sum, part of the proceeds received will be tax free and part will be taxable. The basic concept is that the principal (the face amount) is returned tax free. However, each installment received is part principal and part interest, and the interest portion of the installment is taxable as income.

Federal estate taxes are imposed on estates that exceed certain amounts. Life insurance proceeds are includable in a deceased insured's gross estate:

if the proceeds are payable to the estate, either directly or indirectly; if the deceased possessed any incidents of ownership in the policy at death (such as the rights to change the beneficiary, to assign the policy, or to borrow against the policy); or if the policy was assigned by the insured, other than for full and adequate consideration, within three years of death.

Qualified

means the insured has been certified by a physician as having an illness or physical condition that can reasonably be expected to result in death 24 months or less after the date of the certification.

blackout period

the period of years during which no Social Security benefit is payable to the surviving spouse of a deceased, fully insured worker. It is between the time the youngest child of the worker (in the spouse's case) attains the age of 16 and the spouse's age is 60.