FP514 Module 2.1 - Taxation of Life insurance and Annuity Contracts

A material change does not result from the following:

a decrease in future benefits an increase in death benefits because of dividends a cost of living adjustment to the death benefit

When does a distribution from life insurance becomes taxable event?

a distribution from life insurance contract is treated on a FIFO basis. In other words, the distribution consists first of nontaxable premium dollars. A taxable event occurs only to the extent that the distribution exceeds the investment in the insurance contract. The only exception is when the contract becomes a Modified Endowment Contract (MEC)

Lump sum distribution after the Annuity Start Date

a nonperiodic payment from an annuity contract received on or after the annuity start date is generally fully taxable to the extent that the withdrawal exceeds the investment cost remaining in the contract

Amount of death benefit that is excludible

actual value of consideration paid by the transferee to acquire the contract (cost basis) + Premiums paid + other amounts paid by the transferee subsequent to the transfer

this type of exchange is not allowed under the 1035 exchange

annuity -> life insurance contract

Amount excluded from taxation for fixed annuities

1) Find the exclusion ratio 2) multiple exclusion ratio by the annual return each year to determine the annual amount that is excluded 3) to get the total expected return, multiple the annuity payments by a life expectancy factor supplied by the appropriate treasury table Ex. Assume that Andrew purchased an annuity contract for $360k that provides for payments of $2k/month, and assume that his life expectancy is 20 years at the time the payments are to begin. The total expected return on the contract is $480k ($2k/month x 12 months x 20 years). For tax purposes, the exclusion ratio is the investment in the contract divided by the total expected return. Thus, the exclusion is 75% ($360k/$480k). Of the $2k/month, Andrew may exclude from taxation 75% of that amount of $1500 (return of capital). Remaining $500 is interest and is taxed as ordinary income *If Andrew is still living after 20 years, each incremental monthly annuity payment is then FULLY TAXABLE)

Exclusion ratio for annuities

Annuity payments or periodic payments from a commercial annuity are partially a return of capital and partially interest income. Upon annuitized payments, the return of capital is nontaxable, and the interest is treated as ordinary income.

Advantage of having a Cash Value Life Insurance as an investment

Because of the tax shelter nature of life insurance, what may appear to be a relatively low rate of return on a policy may be better than it seems.

Inside buildup

During the policyowner's lifetime, the accumulation of cash value within the life insurance policy is allowed to grow tax-deferred until it is surrendered. Meaning income earned on money invested in insurance accumulates tax deferred. If one invests in securities, dividends, and interest are currently taxable, as are any realized gains.

What are the benefits of purchasing life insurance in qualified retirement plans?

Main benefit - to the employer - reduced administrative costs main benefit - to the employee - in the event of their premature demise, their survivors will still receive ample retirement benefits. This is a tremendous advantage in a Defined Contribution Plan. If the employee survives to retirement, the benefit can be annuitized. If the employee passes unexpectedly before retirement, the tax computation is complex. However, the net proceeds of the benefit pass tax free to beneficiaries.

When is the investment growth of a life insurance policy not income tax free?

Proceeds payable before death (ex. surrender value) may be taxable if they exceed the insured's cost basis - the investment in the contract. If these proceeds are received as a lump sum payout, the excess over the cost basis is taxable as ORDINARY INCOME (INTEREST INCOME) in that year. If the proceeds are spread out in payments over a fixed period of years, the insured's cost basis is prorated over this period. These amounts received in excess of cost basis are taxed in the year of receipt, just like an annuity.

5 Safe harbor exceptions to the Transfer for Value Rule * none of the proceeds will be includible as income if the following occur *

Sale of the policy is to the insured, insured's spouse, or insured's ex-spouse if incident to a divorce under Sec. 1041 Sale to a business partner of the insured Sale to a partnership in which the insured is a partner Sale to a corporation in which the insured is a shareholder or officer Sale to anyone whose basis is determined by reference to the original's transferor's basis (ex. gift or swap)

Life insurance in Qualified Plans

Tax treatment is different when cash value life insurance is owned inside a qualified retirement plan. Purchase of life insurance must be incidental to providing a retirement benefit. Premiums paid are a taxable benefit to the employee

2 tests that determines a product to be considered as a life insurance product according to the IRC section 7702

The policy must meet at least one of these tests, otherwise the contract will not be treated as life insurance and the cash value part of the policy will be taxable to the current owner: 1) Cash accumulation test 2) Cash guideline premium and corridor test

Downside of contract turning into MEC status

There is no explicit penalty for a policy simply being a MEC. However, it is subject to unfavorable LIFO treatment during withdrawal or loans. For MECs, taxation, like an annuity, is only relevant if the internal cash value is withdrawn or loaned from the policy. Taking the dividends in cash is considered as a taxable event, as is electing to use whole life dividends to offset an outstanding loan. Electing to use dividends to buy paid-up additions could defer taxation on the MEC dividends, and could even eliminate the tax liability upon the death of the insured. If the policyholder withdraws more than the earnings within the contract, then the distribution begins eating the cost basis, and the basis of the contract will be reduced. This will affect the taxation of future withdrawals or loans, if any. An early withdrawal penalty of 10% will typically be imposed on the taxable portion of the distribution made before the policyholder is age 59 1/2.

Material changes in a life insurance contract

any life insurance contract, regardless when it is issued, is also subject to MEC testing even after its first 7 years if there is a material change to the benefits provided by the policy. Once a material change occurs, a new 7-year testing period is started and a new 7-year MEC limit is calculated. Change typically refers to universal life policies; it is often seen when an additional death benefit, typically in excess of $150k, is added to the pre-June 22, 1988, contract without medical underwriting

Seven-pay test (IRC 7702A)

assumes a step process over the first 7 years of the cash value life insurance contract putting too much premium in the life insurance contract, either each year or cumulatively, will trigger MEC status. Essentially, the IRS is asserting that cash value life insurance is simply too good of a tax shelter and it is necessary to curb or regulate its use.

Transfer for Value Rule

can render a portion of death benefit of a life insurance policy as includible in income. applies when a life insurance contract is transferred for valuable consideration (a sale transfer as opposed to a gift or swap transfer). Calculation is necessary to determine the amount of proceeds taxable. commonly seen in both buy-sell arrangements between business partners (or co-shareholders), as well as disposition of corporate owned life insurance (COLI) key man policies when a senior executive of a firm retires

distributions not considered as policy distributions

dividends retained by the insurer to pay premiums or to purchase paid-up insurance or other benefits assignments or pledges, of any part of the MEC, if they are used to cover burial expenses or prearranged funeral expenses if the maximum death benefit does not exceed $25,000

Material changes include the following:

exchange of one policy for another exchange of insured increase or addition of certain riders conversion of a term policy for a whole life contract increase in future benefits (unless the increase is due to the payment of premiums to fund the lowest death benefit or due to the crediting of interest to those premiums) An increase of more than $150k over the death benefit as of Oct 20, 1988

Amount excluded from taxation on Variable Annuity payments

exclusion amount is determined: = investment in the contract / number of expected payments Ex. Carol purchased a variable annuity for $240k and has a life expectancy of 20 years at the time the payments are to begin. Annuity payments are to be made monthly. The number of anticipated payments is 240 (12 months x 20 years). Thus, $1k of each payment is excluded from taxation as a return of capital ($240k/240) entire annuity payment is taxable once the investment in the contract has been recovered

Lump sum distribution prior to the Annuity Start Date

for contracts issued before 08/14/1982, the nonperiodic payment is treated on a FIFO basis. for contracts issued after 08/14/1982, payment is treated on a LIFO basis. In other words, withdrawals consist of fully-taxable interest, and second, tax-free principal to the extent that interest payments are fully exhausted Rules apply to the extent that the cash value surrender value of the contract exceeds the investment in the contract.

When does the 10% early withdrawal penalty not apply for MEC distributions?

if policyholder becomes disabled distribution is annuitized over the life of the policyholder joint lives of the policyholder and a beneficiary

Taxation of Partial Annuitization of Annuity

if taxpayer wanted to access a portion of the funds in an annuity contract, she had to take a nonperiodic distribution. However, the partial annuitization of an annuity is now allowed. If any amount is received as an annuity for a period of 10 years or more, or over one or more lives, under any portion of the annuity contract, that portion of the annuity will be treated as a separate contract for annuity taxation purposes. Thus, holders of nonqualified annuities can elect to receive a portion of an annuity contract in the form of a stream of annuity payments. This leaves the remainder of the contract to accumulate income on a tax-deferred basis This only applies to nonqualified contracts

Types of 1035 Exchanges

life insurance contract -> another life insurance contract life insurance contract -> annuity life insurance contract -> endowment contract endowment contract -> annuity endowment contract -> another endowment contract annuity -> another annuity

Modified Endowment Contract (MEC)

life insurance contract that meets both the state law definition and the IRC definition of a life insurance contract, and fails the seven-pay test. Single premium contracts enjoy tax deferred accumulation inside the contract just like any other cash value life insurance product. If a policyholder wishes to make a withdrawal from a MEC before 59 1/2. then that withdrawal (or loan) will be treated just like a withdrawal from an annuity contract (LIFO basis) Any single premium whole life policy issued on or after June 21, 1988, is considered a MEC MEC rules apply to all contracts issued or contracts that have been materially changed on or after June 21, 1988

Considerations for when doing a 1035 exchange

life insurance contracts require medical and financial underwriting annuity contracts are more typically non-health related and have greater similarity to investment vehicles

Taxation of life insurance proceeds at the death of the insured

life insurance proceeds are typically excluded from the gross income of a beneficiary

Investment in a fixed or variable annuity contract

net cost of the contract as of the annuity start date or total amount of premiums paid reduced by any distributions that were excluded from income

Single Premium Life insurance

one payment, typically of at least $5,000 and usually no more than $1MM. Under the terms, there are no further payments. Payment may be applied to a whole life, universal or variable life policy

superannuation

risk of outliving one's retirement funds

1035 Exchange

specifically states that no gain or loss shall be recognized on the exchange of one life insurance contract for another life insurance contract, annuity or endowment contract. Tax free exchange treatment also applies to the exchange of an endowment contract for an annuity, or another endowment contract providing for payments that start no later than the beginning date under the old contract.

Nonperiodic distribution (lump sum) of an annuity

tax treatment of the distribution depends on whether the payment is made before or after the annuity starting date.

When is the start date of an annuity contract?

when the contract is annuitized or when payments start to occur

Policy distributions

withdrawals or loans taken as cash or used to pay premiums, and dividends received as cash or used to pay a loans