TAXATION OF PERSONAL LIFE INSURANCE

Annuity Phase Benefit Payments

When money is distributed (after age 59½, and the distribution must start by age 70), both the principal and the interest will be taxed at the annuitant's normal income tax rate at the time of withdrawal.

Premature Distributions (including taxation issues)

If money is withdrawn before age 59½, there is a 10% penalty and current-year taxation of the withdrawn amount. There are exclusions to this 10% penalty rule, which include: the money is rolled over to another qualified plan withdrawal for a first-time home purchase (or a house was not owned by the qualified individual within the past 24 months) payment of medical expenses (in excess of 7.5% of the person's adjusted gross income) permanent disability or death of the annuity owner payment of medical insurance premiums during unemployment lasting 12 weeks or longer payment of qualifying post-secondary education costs payment of a federal tax levy. Exceptions If the money withdrawn from a qualified plan is rolled over to another qualified plan, there is no penalty.

TAXATION OF INDIVIDUAL RETIREMENT ANNUITIES (IRAs)

The Pension Reform Act of 2000 allowed for a sliding scale onward from year 2000 of how much can be deducted from the current tax year's income. IRAs include the following: During the accumulation phase, interest grows income tax-deferred. Premature distributions- If money is withdrawn before age 59½, there is a 10% penalty and current year taxation of the withdrawn amount unless the money is rolled over to another qualified plan. Tax is paid on both principal and interest once the IRA is annuitized Upon death, if the annuity has not yet been annuitized, values are included in the annuitant's estate for estate tax purposes. If the IRA has been annuitized, the payments to the beneficiary are taxable.

Taxation of Accelerated Benefits and Viatical Settlements

The proceeds from accelerated benefits and viatical arrangements are not subject to federal income tax, as long as the viator is certified as terminally ill, with a life expectancy of 24 months or less at the time of the transaction. In most cases, however, an individual may still owe capital gains taxes on the difference between the payment received and the amount paid in premiums. No capital gains taxes are owed with the payout of a death benefit as the result of death.

Values Included in Annuity Owner's Estate

Upon death, if the IRA has not yet been annuitized and no beneficiary was named in the annuity contract, values are included in the annuitant's estate for estate tax calculation purposes.

Surrenders

Withdrawals or partial surrenders from a life insurance policy are usually not taxable as long as the withdrawn amount does not exceed the basis. After the policy's basis has been withdrawn, any other withdrawals are subject to income tax. The contract has FIFO withdrawal status after 10 years (FIFO: first in, first out), meaning that withdrawals are treated as coming first from the basis in the contract.

Dividends

Dividends are not generally subject to income tax; dividends are taxable only when they exceed the amount of policy premiums that have been paid in (known as the basis). If dividends accumulate at interest, the interest earned is taxable currently.

IRA Distributions

Early Withdrawal Individuals who withdraw money from a qualified plan before age 59½ must pay a 10% penalty as well as income tax on the withdrawn amount. Mandatory Withdrawal Withdrawals on a traditional IRA must begin by age 70½, and the withdrawals are taxed at that time. There is no mandatory withdrawal age for Roth IRAs. Beneficiary Unlike traditional IRAs, benefits paid to Roth IRA beneficiaries are not subject to income taxes or minimum distributions at 70½.

Amounts Received by Beneficiary

If a beneficiary is named in the annuity contract the annuity is included in the deceased annuity owner's estate and not included in the beneficiary's estate for estate tax purposes, but distributions paid to the beneficiary are still subject to income tax. A spouse who inherits the IRA can elect to treat the IRA as his/her own IRA and can therefore continue to defer distribution until a later time.

Distributions at Death

If the owner dies after annuitization has begun, the remaining payments must be paid out at least as rapidly as under the payout option selected by the owner. If the beneficiary receives the remaining payments under the payout option in effect at the owner's death, the taxable and nontaxable portions of such payments will continue to be determined by the original exclusion ratio.

Policy Loans

Policy loans, except those from Modified Endowment Contracts, are generally not taxable. If a policy is surrendered with a loan outstanding, and if that loan with other cash value is greater than the basis, there is a taxable gain. If a policy lapses, outstanding loans are treated as cash value distributions and are subject to tax on any amount that exceeds the policy's basis.

TAXATION OF PERSONAL LIFE INSURANCE

The major tax advantages of life insurance and annuities are: annual earnings (interest) accumulate on a tax-deferred basis proceeds payable at death are usually income tax-free to the beneficiary. If benefits are paid on a qualified accelerated basis due to the insured's terminal illness, they are treated the same as the death benefit would be treated--i.e., they are not taxed. If an annuity owner dies before the annuity has been annuitized, the annuity is passed on to the beneficiary. Only the amount in excess of the policyowner's investment (the interest/gain) is included in the beneficiary's federal income tax liability.

SECTION 1035 EXCHANGES

1035 exchanges (the name comes from its rule, Internal Revenue Code 1035) allows that no gain will be recognized (taxed) if: one life insurance or annuity is exchanged for another life, endowment, or annuity contract, or one annuity contract is exchanged for another annuity contract with a higher interest rate, and money from one plan must be passed directly from its trustee to the new plan's trustee. The contract's owner may not have direct contact with the cash at any time. Even the transferring of a check to the new plan must be done by someone other than the policy owner.

Tax Treatment of MECs

Modified endowments are subject to more stringent tax regulations, similar to IRA accounts, such as penalties (10%) for cash value withdrawals prior to age 59 ½. If cash value accumulations are more than total premiums paid in, withdrawals will be considered as a withdrawal of earnings first and will be subject to income tax as well as the penalty (LIFO method of accounting--Last In, First Out). MECs do not pass the 7-Pay Test. Lifetime distributions from MECs are taxed on a less favorable "last in first out" or LIFO basis. This means that distributions from MECs are treated as first coming out of the value of the policy's gain portion (if any) and are taxable to the extent of any available gain. Loans from MECs are treated as distributions and thus taxable to the extent of any gain in the policy.

Corporate-Owned

Generally, annuity contracts owned by corporations are not treated as annuity contracts for federal income tax purposes and the earnings (interest) on these contracts are taxed annually as ordinary income received or accrued during the taxable year.

Settlement Options

Insurance proceeds paid as a lump sum to the beneficiary upon death are exempt from federal income tax. If another distribution method is chosen and proceeds are paid in installments, each installment will consist of both principal and interest. The interest portion of each payment is taxable as income.

Cash Value Increases

The growth in cash values is tax-deferred under federal income tax law.

Taxation of Non-Qualified Annuities

Premiums paid into a non-qualified annuity are not tax-deductible. Cash value within any annuity accumulates on a tax-deferred basis. Gains (i.e. interest) on non-qualified annuities are subject to income tax when withdrawn. Non-qualified annuity gains are subject to the 10% penalty tax if gains are withdrawn before age 59½. Any basis withdrawn is not subject to the 10% penalty.

Values Included in Insured's Estate

An insured's estate at the time of death will include: liquid assets held-savings and other accounts, CDs, stocks and bonds, etc. fixed assets held-houses, farms, other physical properties, businesses, personal property other assets-retirement accounts, annuities, life insurance (not included if the owner and beneficiary is someone else) the transfer through gifting of any property including money or the use of or income from property, including assets sold for less than face value and interest-free/reduced interest loans excluded gifts include- the first $14,000 (2016) given to one person during a calendar year gifts for education expenses gifts for medical expenses gifts made to spouses, charities, and political organizations.

Annuity Phase and the Exclusion Ratio

During annuitization, a portion of each annuity payment represents a return of non-taxable investment in the contract and the balance of each payment is considered taxable income. The taxable and non-taxable portions of the payments are determined by an exclusion ratio. The exclusion ratio is determined by dividing the investment in the contract by the total number of expected payments. Once the total amount of the investment in the contract is recovered using the exclusion ratio, the annuity payments are fully taxable.

7-Pay Test

The TAMRA 7-Pay Test looks at the premiums that have been paid in on a life insurance policy. The payment of level premiums over a seven-year period exemplifies a traditional life insurance contract. However, if the total premiums paid in the first seven years exceed the premiums that would have been paid on a level-premium basis, then the life insurance policy becomes an MEC.

Rollover and Transfer Rules

If an investor chooses to take money from a qualified plan before age 59½ the withdrawn amount is subject to penalty fees and taxation during the year the money is withdrawn. IRS guidelines, however, allow for the changing (or rolling over) from one qualified plan to another without making the early withdrawal of money a taxing event. A rollover is the distribution of a retirement account's money to its owner (such as when the owner changes employment), and the subsequent reinvestment of the funds in another retirement plan. The rollover is tax-free if: the funds are deposited into a newly-opened (non-existing) IRA the qualified rollovers must be from one trustee (fund) to another-if the proceeds pass from trustee to the owner and then to another trustee, the proceeds are subject to a 20% tax, which the first trustee withholds from the payment. the deposit of the distributed funds into the new account takes place within 60 days there are no other rollovers during the next 12 months. A transfer is the direct passing of funds between retirement plans and IRAs without the involvement of the account's owner. Unlike a rollover, there is no limit to the number of transfers annually, and there is no 60-day deposit requirement and no 20% withholding.

Conversions & Taxation Issues

Individuals can convert a traditional IRA to a Roth IRA if it is a qualified conversion. The rollover must meet the 60-day rollover time period and must not violate the "one-year" rollover rules. When the traditional IRA was originally used as a qualified plan, the investor was able to deduct the deposited amount from income taxes. Roth IRA contributions are not deducted from income tax. Funds converted from the traditional IRA-whether originally deposited funds or the interest thereon-will become subject to income taxation at the investor's normal tax rate. If, however, part of the funds from the prior IRA consisted of funds that were non-deductible contributions that portion will not be taxed again at the time of conversion. No Penalty- Because both are qualified plans, there is no 10% penalty for an early withdrawal from the traditional IRA account when rolling over to a Roth IRA.. "Rollover" contributions (from a traditional IRA to a Roth IRA) may subsequently be withdrawn tax free and penalty free after the "seasoning" period (currently 5 years). Earnings may be withdrawn tax free and penalty free after the seasoning period if the condition of age 59½ (or other qualifying condition) is also met. (This differs from a traditional IRA where all withdrawals are taxed as ordinary income, and a penalty applies for withdrawals before age 59½.)

Accumulation Phase

(tax issues related to withdrawals) Partial withdrawals from an annuity in the accumulation phase are taxed on a last in, first out (LIFO) basis, i.e., withdrawals from an annuity are made from earnings first, and the owner is taxed on these payments until all of the earnings have been distributed.

Traditional IRAs

An IRA can only be funded with cash or cash equivalents. Contributions paid into a qualified traditional IRA plan may be tax-deductible in the year paid in, depending on the contributor's tax filing status, adjusted gross income, and his or her eligibility for participation in an employer-sponsored tax-qualified retirement plan. During the accumulation phase (when money is being put into the account and the account has not been annuitized), interest grows income tax-deferred. These funds, along with the interest within the IRA, are taxed when withdrawn from the account. Taxes include those on all of the capital gains, interest, dividends, etc., that were earned over the past years.

Premiums

As a general rule, premiums paid for either a life insurance or annuity contract are not deductible for federal income tax purposes. Exception: Qualified IRAs--Premiums paid into a qualified IRA annuity plan are tax-deductible in the year paid in. These funds, along with the tax-deferred interest within the IRA are taxed when withdrawn from the account. If funds are withdrawn before age 59½, there is also a 10% tax penalty that must be paid.

Federal Estate Tax

Estate tax is a tax by the federal and many state governments on a person's right to transfer property at death. Life insurance owned by one individual on the life of another that lists someone other than the insured as the beneficiary passes to the beneficiary without going through probate and is not subject to federal income tax. It is included in the estate for federal estate tax calculation purposes. NOTE If an insured owns a life insurance policy on his own life, or proceeds are payable to the insured's estate, or if the insured possessed any "incidents of ownership" in the policy at the time of death, (i.e., the right to change the beneficiary or assign the policy to someone else) the proceeds will be included in his estate and incur estate taxes before benefits are paid to a beneficiary of the estate. If the policy ownership was assigned by the policyowner to another within three years of death unless the insured received adequate consideration for the transfer of ownership (the assignee bought the policy from the insured), estate taxes are payable. If the policy is not owned by the insured, death proceeds are payable directly to the beneficiary with no estate taxes- estate taxation can be escaped by having someone other than the deceased policyowner own the policy and all of its attendant rights.

Distributions

Tax penalties (10%) apply to cash value withdrawals prior to age 59 ½. If cash value accumulations are more than total premiums paid in, withdrawals will be considered as a withdrawal of earnings first and will be subject to income tax as well as the penalty (LIFO method of accounting-Last In, First Out).

Contributions and Contribution Limits

Contributions can be made to a Roth IRA, a traditional IRA, or a combination of the two. However, the limits apply whether contributing to a single fund or a combination of the two. Direct contributions to a Roth IRA are NOT tax-deductible. The important point of the Roth IRA is that distributions of both principal and interest are income tax-free if the Roth IRA is over five years old and the owner is 59½ or older when distributions are made.

Modified Endowment versus Life Insurance

Life Insurance For a life insurance policy to continue to be considered a pure life insurance policy, IRS guidelines maintain that: 1. cash value accumulations cannot exceed a specified percentage of the cost of future pure insurance benefits 2. the premium payments on the policy must pass the "corridor" or 7-Pay Test. Benefits of life insurance over MECs include: lifetime distributions from regular (non-MEC) policies are taxed on a more favorable "first in first out" or FIFO basis Such distributions are treated as first coming out of the policy's basis (premiums paid in) and are taxable only after the the value of the basis has been fully recovered loans from non-MECs are not treated as distributions and are not taxable as long as the contract stays in force. MECs Modified Endowment Contracts are the result of the Technical and Miscellaneous Revenue Act of 1988 (TAMRA), which changed the definition of a life insurance contract with regard to tax purposes. This was done primarily to discourage the use of life insurance policies as tax shelters.

Taxation

Life insurance policy proceeds are distributed to the beneficiary designated in the policy. Life insurance proceeds received in a lump sum are received income tax-free. Life insurance proceeds can also be converted to an annuity and be paid out over time, with interest added to the amount. Each payment has two portions-death benefit and interest. The interest portion of each payment received by the beneficiary in these situations is subject to income tax. When an annuity is annuitized and payments are made to the annuitant, the IRS has ruled that a fixed portion of each payment (the exclusion ratio) is considered to be return of capital and is not subject to income tax. The portion of each payment considered as interest or growth is subject to income tax.

General Rule and Exceptions

Taxation of death benefit proceeds varies depending on how premiums were paid. If premiums were paid with after-tax dollars, the proceeds of the insurance policy are income tax-free to the beneficiary upon the insured's death. If the premiums have been paid with pre-tax dollars, as is sometimes the case with business insurance, the proceeds of the policy are taxable.

Cash Surrender and Taxes

When an insurance policy is surrendered for its cash value, only the proceeds in excess of the cash paid into the policy as premiums are subject to income tax. Income Tax Interest within a cash value policy accumulates on a tax-deferred basis. Income tax on the interest is payable at a future date when the money is effectively received by the owner, as is the case when a policy is canceled and the cash value is payed out before the insured's death. Taxation of death benefit proceeds varies depending on how premiums were paid. If premiums were paid with after-tax dollars, the proceeds of the insurance policy are income tax-free to the beneficiary upon the insured's death. If the premiums have been paid with pre-tax dollars, as is sometimes the case with business insurance, the proceeds of the policy are taxable. Insurance proceeds paid as a lump sum to the beneficiary are exempt from federal income tax. If another distribution method is chosen and proceeds are paid in installments, each installment will consist of both principal and interest. The interest portion of each payment is taxable as income. Life Insurance Dividends and Taxes Dividends are not subject to current income tax, but interest received on the dividends is subject to current income tax.