Taxation of Life Insurance and Annuities

Section 1035 (Policy Exchanges)

According to Section 1035 of the Internal Revenue Code, the IRS does not levy an income tax against an individual when he or she exchanges one policy of similar nature with another since neither loss nor gain occurs as a result of such transfer. All of the policy's funds are exchanged from one investment vehicle to another. Neither the policy's principal nor any accumulated interest is taxable as a result of such exchange since the contract's funds were not distributed to the individual

Modified Endowment Contract (MEC)

An over-funded life insurance policy that, according to its premium contributions within the first 7 years of the policy, has disqualified itself from the IRS tax advantages of a life insurance contract, and is no longer considered to be life insurance by the IRS. The tax consequences of a policy that is determined to be a MEC affect a policy's cash distributions. The tax consequences of a policy deemed to be a MEC affect its cash distributions including policy loans, surrender value, withdrawals or the use of the policy as collateral on a loan. Unlike that of a life insurance policy, a MEC is subject to ordinary income tax on any gains earned on the invested premium, as well as a tax on the return of premium to the policyowner. However, a MEC still provides a policy's beneficiary with a tax-free, lump-sum death benefit, just as with traditional life insurance, if the beneficiary chooses to receive a lump-sum death benefit.

Non-Qualified Annuities

Annuities that are funded with non-deductible, after-tax dollars (income that has already been taxed) and are purchased by individuals and the self-employed.

Qualified Annuities

Annuities that are funded with pre-tax dollars paid through an employer-based IRA or other qualified retirement plans such as Keogh or TSA plans on behalf of the employee. In regards to contributions paid into an annuity, pre-tax dollars provide an annuitant with greater fund growth in comparison to after-tax dollars.

Guideline Premium Test (GPT)

As an alternative to the CVAT, the GPT focuses on premium limits in relation to the death benefit. Premium paid into the policy is limited by the death benefit amount purchased, as well as the age of the individual and health status.

Death Benefit Proceeds

Death benefit proceeds are paid income tax-free to a policy's beneficiary if proceeds are paid out as a lump-sum amount. If the beneficiary elects to receive continual income payments, or 'installments,' from the death benefit instead of a lump-sum amount, only the interest that accrues from the principal is taxed as ordinary income to the beneficiary, but not the actual death benefit amount.

7-Pay Test

Determines the policyowner's cumulative premium payment limit that can be paid into a life insurance policy within the first 7 years of being in force to ensure that the contract is intended as life insurance and not a short-term, tax-sheltered investment vehicle. A life insurance policy is deemed to be a MEC in any year within the first 7 years of the contract when a policyowner pays into the life contract more than the 'sum of the net level premiums' that would have been paid into the policy on a guaranteed 7-year whole life policy.

Dividend Returns

Dividends paid out to participating policyowners in a mutual life insurance contract are considered to be a reimbursement of premium paid to the insurer and are paid back on a tax-free basis; however, any interest paid to policyowners in addition to the premium reimbursement is considered to be income and is taxable.

The Technical and Miscellaneous Revenue Act (TAMRA)

Federal legislation that helped define the tax consequences associated with misusing life insurance primarily as an investment vehicle, instead of its purpose of providing financial protection against possible loss. Under TAMRA, flexible premium life insurance contracts are regulated by placing a limit on an individual's premium contributions and monitoring the contract to ensure that it is not 'over-funded' within the first 7 years of the policy. In order to deter short-term investments from being tax shelters, he IRS monitors the funding of life insurance through what is known as the '7-pay test.' If a life insurance fails the 7-pay test, it no longer represents a life insurance policy, and instead, is classified as a 'modified endowment contract,' at which point the policy's living benefits become taxable as ordinary income, in comparison to non-taxable living benefits found in life insurance.

Pre-MEC Refund Period

If a life insurance policy reaches the status of being a MEC within any of its first 7 years in force, the policyowner has the remainder of the 'contract year,' meaning the 12-month period of time from the policy's effective date in which the policy is in violation of the 7-pay test, to request a refund of the over-funded premium amount from his or her insurer in order to avoid the contract becoming a MEC

Policy Loans

In a life insurance contract, a policyowner can withdraw funds in the form of a policy loan without being taxed. Since a loan must be paid back, including accrued interest, it is not taxed; however, if the policyowner surrenders his or her policy, an income tax is levied against any gain in the policy's loan value amount. If the policyowner dies before repayment of the loan, the policy's death benefit is reduced by the amount of outstanding loan and accrued interest, with the remainder lump sum being tax free for the beneficiary (unless a recurring payment option is selected

Exclusion Ratio

In order to determine the taxable portion of the payment, the IRS utilizes an Exclusion Ratio, defined as the 'investment' in the contract divided by the 'expected return'. Investment / Expected return = Exclusion ratio

Policy surrenders

In the event that a policyowner surrenders his or her policy to the insurer, proceeds equaling the premium paid into the policy are tax free, while policy surrender proceeds that exceed the cost of the policy are taxable by the IRS. Any pre-tax premium payments and interest earned before forfeiting the plan are taxable as earned income.

Policy Interest Accumulation

Interest earned on a life insurance policy is part of the policy's 'cash value accumulation,' and is considered deferred income, taxed only when policy funds are distributed from the investment. Allowing interest to grow at a compounded rate without taxation over the policyowner's lifetime provides a much greater return from the invested funds.

Policy Funding

Neither life insurance nor annuity premiums are tax deductible for any type of life insurance policy or annuity, except for a percentage of an individual's contribution in an individual retirement account or individual retirement annuity.

Group Life Insurance

Premiums paid by the employer are tax deductible for the employer as a form of business expense. Employee premium contributions are not tax deductible; however, employees do not need to report their employer-paid premiums as income as long as their policy coverage is $50,000 or less. death benefit proceeds are tax free

Last In, First Out (LIFO)

Regarding the taxation of non-qualified annuities, after-tax deposits are considered to be deposited into the account first and any interest that was earned is deposited into the account last. Under the LIFO rule, the interest is considered the 'first out' of the annuity and is taxed as ordinary income. Each annuity payment will be taxed accordingly until all earned interest has been distributed from the account, at which point all taxation on the annuity ends, leaving the after-tax principal disbursement as a means of reimbursement to the annuitant or beneficiary.

The 'Non-Natural Person' Rule

The IRS further defines its requirements in providing tax advantages for annuity contracts by also restricting contracts purchased and maintained by non-living, corporate- or trust-owned entities and consider them to be 'non-natural,' thus disqualifying them to receive the same IRS tax advantages provided to 'natural,' living individuals. As an exception to this tax rule, if an entity or trust is 'acting as an agent for a natural person,' it represents and is taxed the same as a natural person, thus receiving the same tax-deferred growth on annual earnings as a natural person.

Taxable Event

The IRS levies an ordinary income tax on any money being distributed to a policyowner or beneficiary as a result of earned income.

IRS Taxation

The Internal Revenue Service administers and regulates taxation on life insurance, annuities, endowments, and other retirement funds including individual retirement accounts.

Transfer

The process of moving funds from one financial institution directly to another without the withdrawal or distribution of such funds to the individual. The IRS does not levy tax on transfers, nor does it limit the frequency of such transfers by the individual.

Rollover

The process of reinvesting distributed funds from one account into another. The IRS does not levy tax on distributed funds that are rolled over into another retirement plan, but does require an individual to rollover distributed funds into another account within 60 days of such distribution. The IRS also requires the individual's employer to distribute retirement funds directly to another retirement plan in order for the individual to avoid 20% of the funds being held by the distributing fund institution, known as a 'mandatory withholding' requirement, for a specific period of time after such rollover occurs

Accelerated benefits and Viatical settlements

Under current laws, as long as a policyowner is considered to be chronically or terminally ill, both accelerated benefits and policy proceeds from a viatical settlement are paid out on a tax-free basis.

Cash Value Accumulation Test (CVAT)

Under this test, limits are placed on how much cash value can be maintained in relation to the face amount of insurance purchased.

Estate Taxes

Upon the death of an insured individual in a life insurance policy, federal and state inheritance estate taxes are mandated for policy proceeds that are included in the estate of the insured. To avoid this estate tax, the insured can transfer ownership of his or her life contract to the designated beneficiary, but the transfer must be completed at least three years before the death of the insured. Under the 'three-year look back' rule, the IRS can still levy estate taxes on the insured's estate if transfer of ownership to the beneficiary occurs within three years of the insured's death