Life Insurance: The Tax Fundamentals

It’s tax season—and that means you’re probably seeing clearly where your tax exposure is greatest and where there’s room for improvement in your overall planning strategy. That being the case, it’s a good time to revisit the fundamentals of life insurance taxation—which may or may not be on your mind as a part of your holistic estate and wealth planning strategy. Looking into life insurance tax more closely and understanding how it works will help you achieve your life insurance goals (and your tax planning goals) safely and efficiently.

Transfer for Value

Generally, life insurance death benefits are income tax–free. However, when a change in ownership occurs in return for valuable consideration of any kind, the death benefit does become taxable. Note that, under its definition, valuable consideration can be something other than cash or property. Valuable consideration could even be a promise to do something.

The death benefit may retain its tax-free nature, however, if the transfer of ownership is to a person or entity that falls under a specified exception. These excepted transfers are:

  • To the insured or the insured’s grantor trust
  • To a partner of the insured
  • To a partnership in which the insured is a partner
  • To a corporation in which the insured is an officer or shareholder
  • To certain carryover basis transferees

Taxation of Premium Payments

Regardless of whether a policy is owned personally or by a business, life insurance premiums are generally not deductible for income tax purposes.

Taxation of Policy Dividends

For income tax purposes, dividends are treated as a return of unused premium and aren’t taxed. If they are received in cash, they reduce the owner’s cost basis. The reduction in cost basis will affect you from an income tax perspective if you decide to cash in your policy or if your policy lapses or matures. If left on deposit, the earned interest is taxable in the year in which it is available for withdrawal. Accordingly, it’s important to understand the tax consequences of the dividend options you have available.

Corporate Alternative Minimum Tax

If a C corporation is the owner and beneficiary of a life insurance policy, the cash value buildup and the death benefit may be included in calculating whether the corporation may be subject to alternative minimum tax (AMT). Since AMT could be higher than your ordinary income tax rate, work with your tax advisor to understand the implications of cash value buildup and death benefits on your tax liability.

Taxation upon Surrender Or Maturity

When a policy is surrendered (cashed in) or matures, its cash values are taxable as ordinary income to the extent they exceed the owner’s cost basis in the policy. Cost basis is total premiums paid less any untaxed distributions, and it doesn’t include premiums for accidental death, waiver of premium, disability benefit riders, or loan interest paid.

Generally, any loss incurred in connection with the surrender of a life insurance policy is nondeductible as a personal expense.

Taxation of Cash Value and Withdrawals

Generally cash value grows tax-deferred. Assuming the policy isn’t a modified endowment contract (MEC) policy (see below), distributions taken as withdrawals aren’t taxed until the policyholder’s entire cost basis has been withdrawn. Once the entire cost basis has been withdrawn, any future withdrawals would be subject to income tax. Distributions taken as policy loans, however, may not be subject to income tax at the time of receipt.

Be aware that if you reduce your death benefit within the first 15 years of your policy, it may cause cash to be distributed in order to qualify as life insurance. If this occurs, any gain will be distributed first and therefore may be subject to income tax.

Taxation of Policy Loans

With the exception of MECs, policy loans aren’t taxable transactions. Although these loans aren’t taxed when they are taken out, there’s the potential for tax if a policy is surrendered, lapses, or is exchanged with the loan still outstanding. If a policy is terminated other than by death of the insured, the outstanding loan is taxable to the extent there is gain in the policy. The formula for calculating the gain is cash surrender value plus the outstanding loan, less cost basis.

Taxation on the Sale of a Policy to a Third-Party Investor

When a policy is sold in the secondary market, the seller is taxed on the difference between the selling price of the policy and the seller’s cost basis. The seller will recognize income tax on the difference between the cost basis and the cash surrender value, and anything above the cash surrender value will be treated as capital gains. In a term policy, all gains will be treated as capital gains, since there’s no cash value buildup for the ordinary income treatment to apply on. In determining cost basis, the total premiums paid will be reduced by the cost of insurance protection.

Modified Endowment Contracts

A MEC is any life insurance policy in which the cumulative premiums paid during the first seven years exceed the amount needed to satisfy the premiums in seven level annual payments. All withdrawals are taxable until the gain in the policy has first been withdrawn. In addition, policy loans and the use of MECs as collateral are taxable to the extent there is gain in the policy. Note that any distribution from a MEC before age 59½ is subject to the 10 percent premature-distribution penalty.

1035 Exchanges

A tax-free exchange applies when one life insurance policy is exchanged for another. The basis in the old policy is carried over to the new contract. Under IRC Section 1035, tax-free treatment applies under the following conditions:

  • The exchange is a single, integrated transaction.
  • The insured and the owner are the same on both the old and new contract.
  • The life insurance policy is exchanged for another life insurance policy, a MEC, or an annuity. Note that annuities or MECs cannot be exchanged into traditional life insurance policies.

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Your life insurance should be viewed as part of your overall tax planning. The understanding of life insurance taxation and how it works with respect to your assets will help you and your advisors make appropriate tax, business, financial, and estate planning decisions.

Talk to your Moss Adams professional to learn more on how to evaluate insurance alongside other financial and tax planning considerations.