Federal Tax Considerations and Retirement Plans Flashcards
Premiums
For individuals, premiums are considered a personal expense and are not deductible. They are paid with after-tax dollars. This establishes a cost basis in the policy for tax purposes
Cash Values
A cash value policy will experience increases in the cash value annually. Part is from the premium and part is from any interest or gains. The interest or gains are not taxable at the time they are credited to the policy.
Cost Recovery Rule.
Any earnings in the cash value are allowed to grow on a tax-deferred basis until one of the following events occurs:
The policy is surrendered
The policy is transferred for value (sold or assigned)
The policy ceases to meet the IRS definition of a life insurance contract
If the policyowner does sell, surrender, or withdraw funds from the policy, the difference between what is received and what had been paid in is taxed as ordinary income.
First In, First Out, or FIFO
When withdrawing cash from a cash value life insurance policy, the amount of withdrawals up to the policy’s basis will be tax free.
The Cost Basis
The Cost Basis is the amount of premiums paid into the policy less any dividends or withdrawals previously taken.
Policy Loans
If a policyowner takes out a loan against the cash value of a life insurance policy, the amount of the loan is not taxable
This is true even if the loan is larger than the amount of the premiums paid in. The loan is not taxed as long as the policy is in force.
If the policy lapses with a loan outstanding, the excess over cost basis becomes taxable as ordinary income.
Dividends
The dividends themselves are not taxable since dividends are considered a return of unearned premium.
If dividends are left with the insurance company to earn interest, the interest is taxable as ordinary income in the year earned. If dividends received exceed the total premium paid for the life insurance policy, the excess dividends are then considered taxable income.
Death Benefit Proceeds (Claims)
The death benefit, or face amount, of the policy is generally not considered taxable income when paid as a lump sum death benefit to a named beneficiary.
If a settlement option is used instead of a lump sum payment, any interest or earnings component of each payment are considered taxable as ordinary income.
Estate Taxes and Benefits Included
Benefits may be included in the insured’s estate, either intentionally or by default.
The policyowner may name the estate as a beneficiary, or by default, if no beneficiary is living at the time of the insured’s death, the benefit will automatically be paid into the insured’s estate.
These values will be added to the amount in the estate and potentially be subject to federal estate taxes.
