Taxation of Personal Life Insurance

Seven-pay Test

Premiums paid cannot cause a policy to be paid-up after seven years.

TAMRA

Tax Reform Act of 1984. This act restricts the payout of endowment policies.

Surrenders Example

Tom surrenders his whole life insurance policy with total cash value $200,000; however, he has only paid $110,000 of premiums. The additional $90,000 is taxable.

Taxation of Personal Life Insurance

As a general rule, premiums for life insurance policies are not tax-deductible and proceeds from life insurance policies are tax-free if received in a lump sum. If proceeds are received in installments, a portion of the proceeds will contain interest, which is taxable.

Business Life Insurance

Life insurance policy premium payments are not tax-deductible as a business expense if the company is using the policy for business purposes; however, the proceeds are tax-free. The exception to this is when a business purchases group insurance for the benefit of its employees.

Distributions

Modified endowment contracts are subject to the last in, first out rule which means when a withdrawal from a modified endowment contract is made, the first dollars received are interest, and as such are taxable as ordinary income. Furthermore, if withdrawals are made prior to the policyowner reaching the age of 59½, the IRS assesses a 10% penalty tax on the interest. Distributions from a normal life insurance policy are only taxable up to the amount in excess of premium payments. Under a modified endowment contract, all withdrawals and surrenders are taxable. Cash value builds tax-deferred, and the death benefit is tax-free to the beneficiary if received in a lump sum.

Collateral

A collateral assignment is the partial and temporary transfer of ownership rights to another person or entity. Synonymous with partial and conditional assignment.

Modified Endowment Contracts (MEC)

Congress and the IRS have defined life insurance with guidelines for protecting the tax advantages associated with owning a life insurance policy. The rules are designed to prevent over-accumulation of policy funds that allow individuals to avoid taxation for investment activities under the guise of life insurance. Modified endowment contracts are over-funded life insurance policies in which proceeds are subject to taxation.

Divisible Surplus and Dividends

Divisible surplus is the amount of earnings paid out after the insurance company sets aside funds required to cover contractual obligations, operating expenses, contingencies (such as worsening mortality or economic conditions), and general business purposes. Divisible surplus funds are 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 premiums, they are considered not taxable because premiums are paid with after-tax dollars. Interest earned on dividends is taxable income.

Policyowners may take out a loan against their life insurance policy cash value:

-The borrowed money is not taxable. -The insurer will charge interest on loans that have not been repaid. -Loans are repaid or recovered upon policy surrender or maturity.

Which of the following is true regarding the taxation of universal life insurance policies?

Cash value grows tax-deferred, but may be subject to taxation upon withdrawal.

Surrenders

Upon policy surrender, any cash value greater than the amount of premiums paid in is subject to tax.

Accelerated Benefits

Accelerated benefits are received income tax-free as long as the distribution is qualified. This means that the insured is suffering a terminal illness that is expected to result in death within two years.

Settlement Options

Life insurance proceeds are paid to the beneficiary upon the insured's death. -Proceeds are tax-free if received in a lump sum. -Proceeds received in installments are subject to tax because the death benefit is reinvested into an annuity that grows interest. -Each payment contains principal (the death benefit) and interest. -The interest-portion of each payment is taxable.

Cash Value Increases

In whole life insurance policies, premiums build cash value. The cash value increases as interest is earned on the premiums, and grows tax-deferred. The policyowner can borrow against the policy cash value. If the policy cash value is surrendered or endows, the interest is taxable as ordinary income. The beneficiary receives the death benefit tax-free.

Erin bought a $100,000 whole life insurance policy. When she is 65 she decides to surrender the policy for its cash value of $60,000. Of the cash value, $50,000 is premiums. How much of Erin's cash surrender is taxable?

$10,000 The difference between the cash value and the premiums paid is taxable upon policy surrender ($60,000 - $50,000 = $10,000).

Modified Endowment Versus Life Insurance: Seven Pay Test

To determine whether a life insurance policy is a modified endowment contract, the IRS developed the seven-pay test under TAMRA, the Technical and Miscellaneous Revenues Act. To pass the test, the premiums paid during the first seven years of the policy may not exceed the total amount of level annual premiums that would pay-up the policy in seven years. If the policy fails the seven-pay test, it is considered a modified endowment contract. If the policy death benefits are increased, the policy undergoes an additional seven-pay test. The earliest age at which a life insurance policy may endow is age 95. The 2001 C.S.O. tables increase that age to 120.

Amounts Received by Beneficiary Example

Bob has a $700,000 whole life policy. He has paid $500,000 in premiums and the policy has a cash value of $470,000. If Bob dies, how much in taxes will his beneficiary pay? Remember that life insurance death benefits are tax-free if received in a lump sum. The cash value is part of the death benefit, and is, therefore, not taxable. Bob's beneficiary will not pay taxes on any part of the $700,000 death benefit.

Amounts Received by Beneficiary General Rule and Exceptions

Generally, beneficiaries receive life insurance proceeds tax-free if received in a lump sum; however, proceeds from life insurance policies that result from a transfer of value, or were sold to another party, may be subject to taxation. The transfer of value rule does not apply when a life insurance policy is assigned as collateral on a loan.

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 installment