Taxation of Individual Life Insurance Flashcards
Life Insurance Premium Payments are taxed unless under what 4 circumstances?
Life insurance premiums are generally not tax deductible, whether the insurance is used for personal or business purposes.
There are a few exceptions.
- Life insurance premiums are tax deductible when a qualified charitable organization owns the life insurance;
- an ex-spouse pays for the life insurance as part of an alimony decree;
- the life insurance is provided under a group policy that the employer pays for as an employee benefit expense;
- or a business creditor buys the life insurance as collateral security for a debt.
Taxation of Life Insurance Death Benefits
Life insurance settlements can be paid in any of the following options, each of which accrues taxable interest on proceeds held by the insurer:
When paid out in a lump sum, what 2 tax rules apply?
Death benefit proceeds from a personal life insurance policy are generally not subject to income taxation.
Life insurance settlements can be paid in any of the following options, each of which accrues taxable interest on proceeds held by the insurer:
- interest only
- fixed period
- fixed amounts
- annuitized over the beneficiary’s life
To summarize: When life insurance death benefits are paid in a form other than a lump sum, the beneficiary:
- owes taxes on any interest earned on the undistributed death benefit and
- does not owe taxes on the principal amount of the death benefit, whenever it is paid out.
If a life insurance policy is Transfered-for-Value (or sold), the death benefits may be ____________
What is the taxable gain?
The transfer-for-value rule does not apply if the transfer is made to which 3 parties?
While life insurance death benefits generally avoid income taxation, there is an exception.
If a life insurance policy is transferred for value (i.e., sold) to another party, the death proceeds may be income taxable.
The portion of the death benefit includable in the beneficiary’s income for tax purposes equals the gain in the policy. The gain is calculated as follows:
death benefit amount – amount paid by new owner to purchase the policy – premiums paid by the new owner = taxable gain
Exceptions to the Transfer-for-Value Rule
If a transfer is made to any of the following—even for consideration—then the death benefits are not income taxable:
- the insured individual
- a business partner (or the partnership) of the insured
- a corporation in which the insured is an officer or shareholder
Estate Taxation of Life Insurance Death Benefit
A decendent’s estate will include the death benefit if what 3 things exist?
QUESTION: Don’t all life insurance policies have an incident of ownership even if a beneficiary is in place?
The decedent’s estate will include the amount of the proceeds under the following conditions:
- The proceeds are paid to the executor of the decedent’s estate.
- The decedent had an incident of ownership at the time of death. (include the right to terminate, to take loans from cash value, to assign, and to name and change beneficiaries).
- The decedent transferred ownership of the policy within three years of death.
If the total estate value exceeds the estate tax exemption amount current at that time, the excess amount is subject to federal estate taxation.
Taxation of Life Insurance Cash Values
If paid out as death benefit, then tax ______
If paid out as a withdrawal, then tax ______
If paid out as a policy loan, then tax ______
Depending on how they are used, life insurance cash values may or may not be taxable.
- If they are paid out as part of the death benefit, at the insured’s death, they effectively becomes income tax-free.
- If withdrawn then the amount that exceeds the premiums paid is taxable
The question of taxability then hinges on whether the distribution is due to a
- cash value withdrawal (i.e., full or partial policy surrender) or
- a policy loan
Policy Surrenders are treated like “first-in, _______”
When a policyowner withdraws the policy’s cash value the amount that exceeds the premiums paid is taxable as ordinary income (not capital gains).
Cash value withdrawals from life insurance are generally treated on a favorable “first-in, first-out” basis so they are considered tax free because they were taxed going in.
This means that a partial surrender might not be a taxable event as long as the withdrawn amount is less than the sum of premiums paid.
Because accrued interest is “last in,” it is not taxable until after the sum of premiums have first been withdrawn. Once a partial surrender is offset by the sum of premiums paid, that amount of premiums paid cannot be used to offset a second withdrawal.
For example, Tim owns a universal life policy for which he pays an annual premium of $1,000. He has paid a total of $12,000 in premiums, and the policy has a $20,000 cash value. If Tim makes a $10,000 withdrawal he will avoid taxation because it is less than the sum of premiums paid. A year later, the sum of premiums paid is $13,000. Were he then to make a $5,000 withdrawal, he would face an income tax liability on $2,000 of that amount. That is because he already used $10,000 of the premiums paid in offsetting the first withdrawal, and only $3,000 remains available to offset the second withdrawal. Here is another way to look at this:
$15,000 total withdrawals - $13,000 total premiums paid = $2,000 taxable withdrawal
Policy Loans are not taxable because ….
What are the 2 exceptions?
Policy loans are not cash value distributions but are loans from the insurer, which uses the cash value as collateral.
Since no withdrawal is being made from the cash value, no taxes are owed.
There are two notable exceptions:
- If the policy is later surrendered, then unpaid loan balances are paid off using the cash value. At that point there may be an income tax liability to the extent the loan pay-off amount exceeds the sum of premiums paid.
- If the policy is a modified endowment contract (MEC), the loan may be taxable.
Life insurance policy dividends are a return by the insurer of excess premiums called “__________ _________” and therefore are not taxable. As a general rule, policy dividends are not taxable when they are
- paid …
- used to …
- used to …
What is the two exceptions?
Premiums are not tax deductible, so it makes sense that a return of that money to the policyowner should be tax free. Life insurance policy dividends are a return by the insurer of excess premiums (called “divisible surplus”) and therefore are not taxable. As a general rule, policy dividends are not taxable when they are
- paid in cash to a policyowner,
- used to reduce premiums, or
- used to buy additional insurance.
The two exceptions:
- Interest earned on dividends under the “accumulate at interest” dividend option is taxable in the year credited.
- In the rare instance where the sum of dividends paid out exceeds the sum of premiums paid into the contract, the excess dividend amount is recognized as taxable income in the year it is distributed to the policyowner.
Taxation of Accelerated Benefits
They are not ______ if the insured meets the criteria.
Must be certified by a doctor as having a condition that can be expected to result in _______ within ___ months.
Many life insurance policies today offer accelerated benefits that pay a portion of the policy’s face amount if the insured becomes chronically or terminally ill.
The accelerated benefit is available through an accelerated benefits rider (or policy provision) or a long-term care rider for people who become terminally ill.
In 1996 with the passage of the Health Insurance Portability and Accountability Act (HIPAA) states that accelerated benefits paid to the insured are not taxable if certain qualifications are met.
These qualifications require the insured to meet the definition of terminally ill or chronically ill;
- must be certified by a doctor as having a condition that can be expected to result in death within 24 months.
Taxation of Endowment Contracts
An endowment pays out in what 2 ways?
As of 1986 what no longer qualifies as a valid life insurance product?
Once a very popular form of life insurance, an endowment is a type of contract that
- pays a lump-sum death benefit at the insured’s death but also
- pays a lump-sum benefit if the insured is alive upon reaching a stipulated age (which often was age 65)
However, endowment contracts purchased after 1986 no longer qualify as life insurance. Accordingly, the cash value does not enjoy tax-deferral status, meaning that each year’s increase in the cash value is reported as taxable income to the contract owner.
Endowment contracts issued before 1986 were grandfathered (meaning they are treated as life insurance for tax purposes) and many continue in force today.
Modified Endowment Contracts no longer receive favorable tax benefits because …
A MEC is not a type of insurance but rather a __________________.
It had become apparent that these new policies offered consumers a way to take advantage of life insurance’s favorable tax treatment by “over-funding” the policy to generate excessive cash values.
A life insurance policy that is a MEC loses the benefit of tax-free cash value distributions (loans as well as withdrawals).
It is important to understand that a MEC is not a unique type of life insurance but a classification assigned to any permanent life insurance policy that violates excessive funding rules of the Tax Code.
Do not confuse a MEC with a traditional endowment contract.
An endowment contract is a specific type of life insurance contract that is rarely sold today.
When does a Life Policy Becomes a MEC?
Answer:
If it fails to meet the ___________ which means the sum of premiums paid exceeds _______________.
A life insurance contract becomes a modified endowment contract and subject to less favorable income tax treatment if it fails to meet the 7-pay test.
The 7-pay test applies to the premiums paid into a contract during its first seven years.
At any point during the first seven policy years, if the sum of premiums paid at that point exceeds the amount required at that point to pay-up the policy within seven years, the policy is designated a MEC.
In other words, a policy does not have to wait seven years to become a MEC. In fact, the target of the MEC rules was single premium life insurance.
Once a policy becomes a MEC it can never revert to a non-MEC status.
If the MEC is used to provide a death benefit, what 2 tax advantages do they still enjoy?
Policies that are deemed MECs still enjoy two of the tax advantages of insurance policies as long as the policy is used for the fundamental purpose of providing a death benefit:
- The death benefit is not taxable as income to the beneficiary if it is paid in a lump sum.
- The cash value grows tax-deferred as long as it stays in the contract.
However, cash distributions from a MEC while the insured is alive are penalized.
Policy dividends, cash value withdrawals, and policy loans are subject to income taxation as follows:
- MEC withdrawals and policy loans are treated on a last in first out (LIFO) basis. That is, they are considered to be distributions first of interest earnings (the “last in”), which are taxable but it keeps your principal the same.
- Dividends received under a MEC, except dividends that are used to purchase paid-up additional insurance, are taxable as income to the extent that the policy’s cash value, exceeds the investment in the contract.
In addition, distributions of earnings from a MEC taken before the owner’s age 59½ are subject to a 10 percent tax penalty.
What is a COLI?
Premiums paid by the business to fund a COLI policy are usually not _________________ .
To meet guidelines the business must obtain _______________________________.
__If _________________ is not obtained before the policy is issued, death benefits will be ___________ to the business whenever paid.
Corporate-owned life insurance (COLI) is any type of individual life insurance covering employees of all levels in which the corporation is both owner and (typically) the beneficiary.
Businesses are permitted to retain the policy even if a covered employee terminates employment.
Premiums paid by the business to fund a COLI policy are usually not tax deductible.
They are paid with after-tax dollars, which helps to assure that the death benefit will be received income tax free by the business at the covered employee’s death.
While COLI death benefit proceeds are generally not subject to income taxation, corporations must follow specific guidelines to assure this.
Most notably, before a COLI policy is issued the business must obtain written consent from the employee.
If written consent is not obtained before the policy is issued, death benefits will be taxable to the business whenever paid.
Obtaining consent after a COLI policy is issued will not reverse this taxable benefit status.
Key Points
- Settlement options that involve accrued interest on death benefit proceeds left with the insurer will result in taxation but only on the interest portion of distributions.
- When life insurance death benefits are paid in a form other than a lump sum, the beneficiary owes taxes on any interest earned on the undistributed death benefit and does not owe taxes on the principal amount of the death benefit, whenever it is paid out.
- The death benefit of any life insurance policy owned by a person (or the person’s estate) when he or she died is included in the value of that person’s estate under certain conditions. These include the person’s possession of incidents of ownership in the policy DEFINITION of ‘Incidents of Ownership’ A person (including a trustee) has incidents of ownership if they have the right to change beneficiaries on a life insurance policy, to borrow from the cash value, or to change or modify the policyin any manner..
- As cash values build within a life insurance policy, they avoid current taxation.
- Life insurance is generally taxed on the FIFO basis, meaning withdrawals are treated first as a tax-free return of premiums. Because accrued interest is ”last in,” it is not taxable until after the sum of premiums have first been withdrawn.
- Policy loans are not cash value distributions but are loans from the insurer, which uses the cash value as collateral.
- Life insurance policy dividends are a return by the insurer of excess premiums (called “divisible surplus”) and therefore are not taxable.
- Interest earned on dividends (under the “accumulate at interest” dividend option) is taxable in the year credited.
- Accelerated benefits paid to the insured are not taxable if certain qualifications are met.
- A MEC is not a unique type of life insurance but a classification assigned to any permanent life insurance policy that violates excessive funding rules of the Tax Code.
- Once a policy becomes a MEC it can never revert to a non-MEC status.
- Cash distributions from a MEC while the insured is alive are penalized.
- Before a COLI policy is issued the business must obtain written consent from the employee (regardless of level or position in the company) whose life will be insured through a COLI policy.
