Federal Income Taxation of Death Benefits
One of the key benefits of life insurance is that the death benefits are generally received by the beneficiary income tax free. This is a significant benefit that enhances the value of purchasing life insurance. While most death benefits are income tax free, there are exceptions that will be covered later. In addition to the benefits paid when the insured dies, some life insurance policies will allow the policyowner to take a portion of death benefits before the insured has died if the insured is either terminally ill or chronically ill. For these early benefits to be received income tax free, they must meet certain requirements.
Benefits for the terminally ill are defined in the Internal Revenue Code as those paid to an insured when death is expected within 24 months. Most life insurance policies that provide accelerated death benefits for the terminally ill will only pay these benefits if death is expected within 6 or 12 months.
To meet the definition of chronically ill the Internal Revenue Code says that the insured must be certified by a doctor as unable to perform two or more activities of daily living (which include eating, toileting, transferring, bathing, dressing and continence) and these limitations are expected to continue for at least 90 days.
Benefits are also payable if the insured suffers from a severe cognitive impairment. Life Insurance Owned by And Payable to Employer Death benefits paid under a life insurance policy that is owned by and payable to an employer will be received income tax free by the business only if the employer complies with certain requirements. The first requirement is that the employee must be notified that the employer intends to purchase insurance on the employee’s life and the employee must consent to be insured. In addition, the death benefits will remain income tax free only if the policy falls within one of four categories, known as “safe harbors.” Finally, the employer must comply with certain annual reporting requirements. The safe harbors are: 1. The insured must have been employed by the employer at any time during the 12 months preceding the insured’s death; 2. At the time of issue, the insured either:
Earned $95,000 or more, or
Was a director, a 5% or greater owner, one of the 5 highest-paid officers, or one of the highest-paid 35% of employees of the business; 3. The death benefit proceeds are paid to a spouse, parent, grandparent, child, grandchild, brother, sister, an individual other than the business named by the insured, a trust set up for any such person, or the insured’s estate; or 4. The business uses the death benefit proceeds to purchase an interest in the business from one of the people listed above.
Transfers for Valuable Consideration
There are other times when the death benefit may not be paid income tax free. These situations generally fall under a provision known as the Transfer for Value Rule. These complex rules are covered only briefly here. The transfer for value rule states that death benefits paid will not be income tax free if some interest in the policy is transferred for valuable consideration, unless the transfer meets a series of exceptions. A transfer of an interest in a policy can take many forms, but the most common is the transfer of the policy’s ownership. But, the transfer of the interest in the policy alone is not sufficient to cause the death benefits to be taxed. The transfer must be accompanied by some valuable consideration. That is, the transferor must receive something of value in exchange for making the transfer.
Example: Joe, the insured, has a life insurance policy with a death benefit of $250,000 and a cash value of $55,000. Joe changes the ownership of the policy to Mike in exchange for $55,000. Both a transfer and the receipt of something of value occurred. Therefore, when the insured dies, the death benefit paid will not be entirely income tax free. Assume that Mike paid 2 additional premiums of $2,000 (total of $4,000) before the insured died. An amount equal to the total premiums paid by Mike plus the amount he paid to Joe will be received income tax free. The balance of the death benefit, $191,000 ($250,000 – [$4,000 + $55,000]) will be subject to income tax. There are some exceptions to the transfer for value rule. The four main exceptions state that if a transfer is made in exchange for something of value, the death benefit will remain income tax free if the transfer is made to:
A partner of the insured;
A partnership where the insured is a partner; or
A corporation where the insured is an officer or shareholder. Another exception, known as the basis exception, is used when someone wants to transfer a policy that is a part gift and a part sale. Discussion of this exception is beyond the scope of this material.
Federal Income Taxation of Cash Value
Life insurance policy cash value provides a source of funds for the policyowner if money is needed to meet an emergency or an opportunity. These cash values also have the added benefit of being income tax deferred. That is, any interest credited to the cash value in the policy is not taxed unless the cash value is removed from the policy. The following summary of the taxation of cash value applies only to policies that are not modified endowments (see section on modified endowments below). If the policyowner surrenders the policy, the cash received will be included in the policyowner’s taxable income to the extent that the amount of the cash exceeds the policyowner’s basis in the policy. Basis is generally the sum of the premiums paid, reduced by the cost of any riders and any prior withdrawals or policy loans (NOTE: other adjustments to basis may be required for dividend paying policies).
Example: Kathy has a universal life insurance policy with an annual premium of $2,000. She has had the policy for 10 years. The policy has no riders and she has never borrowed from the policy or made a withdrawal of any of the cash value. She decides to surrender the policy when the cash value equals $30,000. Kathy’s basis in the policy is the sum of the premiums paid, $20,000 (10 x $2,000). She will have to pay income tax on $10,000 ($30,000 – $20,000). If the policyowner makes a withdrawal from the policy, there will be no income tax payable until the amount of the withdrawal exceeds the amount of the basis. That is, the policyowner is permitted to withdraw the basis first before taking out the taxable gain. Example: Kathy decides not to surrender the policy. Instead, she takes a $15,000 withdrawal from the cash value. Because Kathy’s basis, $20,000, is greater than the withdrawal, Kathy will not have to pay taxes on any of the $15,000. But, her basis will now be reduced to $5,000. If the policyowner borrows money from the life insurance policy, the amount of the loan will not generate any taxable income while the policy remains in force. If the policy lapses or is surrendered, the total amount of the loan will be repaid from the cash value in the policy. The policyowner will be subject to income tax to the extent the total loan, plus cash received, exceeds the policyowner’s basis in the policy. Example: Kathy decides to borrow from her policy instead of taking a withdrawal. She borrows $12,000. The interest rate on her policy is 8%. Rather than pay the interest, she allows the interest to accrue, creating additional loans. Five years later (after paying five more premiums), the outstanding loan is now $17,632. The total cash value in the policy is now worth $42,000. Kathy then surrenders the policy. The loan is repaid from the cash value leaving a net amount paid to Kathy in cash of $18,368. Her basis is $30,000. $12,000 of the $18,368 that she receives will be subject to income tax. This is calculated by subtracting her basis from the total cash value ($42,000 – $30,000 = $12,000).
Modified Endowment Contracts (MEC)
Some life insurance polices are known as Modified Endowment Contracts (MEC) and are taxed a little differently than non-MEC policies. A MEC is a regular life insurance policy to which very high premiums have been paid during the first seven years of the policy, or the seven years following a material change to the policy. The premium level at which the policy will become a MEC may be different for different policies. You can find this premium amount by reading the narrative summary part of the illustration. This premium level is often referred to as the seven-pay test premium. Once a policy becomes a MEC, it will always be a MEC. Withdrawals from MEC policies are treated as coming from the growth on the policy first.
Example: Pete has a life insurance policy with $75,000 in cash value. His basis in the policy is $55,000. If Pete takes a withdrawal of $25,000, $20,000 will be subject to income tax and only $5,000 will be tax free as return of basis. In addition, loans on MEC policies are taxed as withdrawals to the amount of the gain in the policy.
IRC Section 1035 Exchanges
The Internal Revenue Codes (IRC) allows a policyowner to exchange an older policy for a new policy and move the cash value from the older policy to the new policy. The primary advantage of doing this is that it postpones the payment of income taxes on any gain in the cash values and carries over the tax basis from the old policy to the new policy.
Example: John owns a universal life insurance policy on his own life. He has paid $2,000 per year for 15 years and the cash value in the policy is now worth $40,000. If John surrenders the policy he will have to pay income tax on the amount of the cash value that exceeds his basis (total premiums) in the policy. $40,000 – 30,000 ($2,000 x 15) $10,000 of taxable income However, since John is still healthy and still needs the coverage, he might decide to purchase a new life insurance policy with a more favorable design and have the cash value transferred. By doing this, John doesn’t have to pay any income tax on the growth in the cash value as long as it stays in the new policy. And the $40,000 can be used to offset premiums that would otherwise be paid out-of-pocket on the new policy. To make use of IRC Section 1035, the policyowner must follow certain steps. 1. Apply for new life insurance 2. Assign the old life insurance policy to the new insurance company After John has been approved for the new life insurance, the insurance company will surrender the old policy and have the old insurance company send the money to them to put toward John’s new policy.