Generally, life insurance proceeds paid by reason of death are income tax free; however, they could be subject to estate taxes, depending on circumstances that will be discussed later. The reason I qualified the previous statement with the word generally is because of something known as the transfer for value rule, which is defined in IRC §101(a)(2). Thus, if a policy falls under the transfer for value rule, the proceeds, less the amount paid for the policy plus subsequent premiums, would be subject to tax at ordinary income rates. Like any IRS rule there are several exceptions to this rule. This rule is very relevant in light of today’s secondary settlement market.
In addition to the definition contained in IRC §101, contracts issued since 1988 must also meet the definition contained in IRC §7702 to be considered life insurance. If these definitions are met, then the annual increase in cash value is not subject to taxation. If cash value is surrendered (not borrowed), it will be subject to income taxes at ordinary rates to the extent it exceeds the owner’s basis in the policy. Thus it receives favorable FIFO tax treatment, provided the policy is not classified as a Modified Endowment Contract, commonly referred to as a MEC.
A MEC is defined in IRC §7702A, and applies to policies issued after June 20, 1988. If a policy is classified as a MEC, certain taxes and penalties could be applied to lifetime distributions. It is important to note that MEC status does not affect the tax status of death benefits.
Dividends are considered to be a return of premium, and hence are not taxable until the total amount received exceeds the owner’s basis in the policy, at which time they are taxed at ordinary rates.
There are many reasons why an insured may want to change insurance policies. Rather than surrender the current policy and purchase a new one, effectuating an exchange of policies pursuant to IRC §1035 can have certain advantages. The major advantage is that the basis in the old policy carries over to the new policy. That means that if the old policy had a gain, tax on that gain can be deferred, and if the old policy had a loss, that loss can be used to increase the basis in the new policy.
Generally, life insurance proceeds will be included in the insured’s estate if the insured held any “incidents of ownership” within three years of death (IRC §2035). This could be a vital aspect of estate planning if the insured’s estate is large enough to be subject to estate taxation. Inappropriate ownership could negate up to 40% of the value of the life insurance. Thus if the insured’s estate is likely to be subject to estate taxation, proper ownership of life insurance policies is imperative.
These are just a few of the more common issues regarding the taxation of life insurance – there are many more. This is provided as a general overview and should not be relied on as specific tax advice. Should you have a specific question, please contact me or your tax advisor.