Taxation of Insurance Flashcards
Taxation policy for Life Insurance
In most cases, life insurance proceeds are not subject to income taxes. However, life insurance proceeds can be taxed if transfer for value rules apply, or if death benefits are withdrawn early in cases where the insured is terminally ill. Dividends received from a mutual life insurance company are not subject to federal income taxation.
The federal estate tax is a tax upon a person’s right to transfer property on his or her death. Although not a tax on the property itself, it is calculated on the value of such property included in a decedent’s estate. When a life insurance policy was owned by a decedent who was the insured, the death benefit amount is included in the decedent’s estate and is subject to estate tax. If an owner of a life insurance policy transfers that policy during his lifetime to another individual or to an irrevocable trust, that transfer may be subject to gift tax.
Death Benefit Proceeds
Death proceeds are the policy face amount and any additional insurance amounts paid by reason of the insured’s death, less any loans taken against the policy and past due premiums during the grace period. Proceeds must be paid by reason of the death of the insured, which means that the insured’s death must have caused the maturity of the contract.
Incidents of Ownership
Incidents of ownership are the legal rights of the policy owner of a life insurance policy, such as the right to change the beneficiary, the right to take a loan, the right to assign or transfer the policy, or the right to receive cash value or the dividends.
Living Benefits
Living benefits are those that are taken before the death of the insured. They would include dividends, savings and accelerated death benefits. Loans can be taken against cash value for permanent life insurance policies and life insurance policies can be surrendered
Example of Living Benefit
For example, Bill Shakespeare purchased a whole life insurance policy 35 years ago when he was 25 years old. He decides to retire at age 60 and he withdraws the cash value of his life insurance to buy a recreational motor home. Assume Bill’s total premiums ($50,000) less dividends he received ($21,000) equal $29,000. If Bill withdraws $35,000 in cash value, $6,000 ($35,000 - $29,000) is subject to tax. For the past 35 years, Bill has not had to report the interest income on the savings value of the policy. When the withdrawal is made, however, the excess of the cash value over his adjusted basis is subject to the income tax at ordinary rates.
Accelerated Death Benefits
Many insurers allow an accelerated death benefit or the early withdrawal of death benefits in cases where the insured is terminally ill.
IRS regulations provide that payments meeting a three-part test will be identified as a qualified accelerated death benefit:
The insured must be terminally ill.
The reduction of the remaining face value of coverage is limited.
The cash value of the remaining death benefit may not be reduced.
Payments that meet the above criteria are benefits that may be received on the same tax-free basis applying to conventional death benefits.
Example of Accelerated Death Benefit
A single mother was diagnosed as terminally ill with a form of brain cancer. This young woman was able to receive 92% of her life insurance policy’s death benefit in order to prepare for her remaining time with her young daughter. Her policy stated that if she died within 6 months of the payment, the remaining 8% held as an administrative cost by the insurer would be paid as a death benefit. Hospice care was arranged for her at home, so she could be with her family. The balance of the unused money was invested for her daughter’s future, which gave her peace of mind that her daughter would be financially well off. Because she passed away within the 6-month provision of the policy’s accelerated proceeds benefit, the insurer paid the remaining amount, providing additional security on a tax-free basis. However, if the mother had passed away after six months, the additional 8% of proceeds would not have been paid out to her beneficiary.
Transfer for Value
Sometimes a life insurance policy is sold for a valuable consideration. This is known as a “transfer for value”. A life insurance policy that is sold or exchanged for valuable consideration may cause the death benefit to be taxed in certain situations. Under the transfer for value rule the death benefit amount that exceeds the new policy owner-beneficiary’s adjusted basis is subject to income tax at ordinary income rates when the insured dies. The transfer for value rule cannot be avoided by canceling the transaction at a later time
Example of Transfer for Value
Here is an example of the transfer for value rule. Assume that Mother is the owner and the insured on a policy with a death benefit of $400,000, a yearly premium of $7,300, and a cash value of $75,000. Mother sells this policy to Daughter (the beneficiary) for the $75,000 cash value. When Mother dies three years later, then Daughter, as owner/beneficiary, will receive the $400,000 death benefit amount of the policy. The $75,000 amount that Daughter paid for the policy plus the annual premium, which we will assume is $21,900 (calculated as 3 yearly payments of $7,300), is her adjusted basis in the policy of $96,900. The difference between the death benefit amount of $400,000 that Daughter received and her adjusted basis of $96,900 in the policy is $303,100 and is subject to income taxes at her marginal tax rate.
1035 Exchanges
Existing life insurance policies and annuity contracts can be exchanged for new policies and contracts with different insurance companies as a tax-free exchange. This is permitted by IRC Section 1035(a) as a like-kind exchange if the current owner is named the new owner of the policy or annuity contract.
Example of 1035 Exchange
Take as an example a deferred annuity contract owned by Lauren. Lauren bought the annuity from Company A for $100,000. The current value of the annuity contract is $150,000. Lauren wishes to purchase a better annuity contract from Company B. If Lauren surrenders the annuity from Company A to buy a new $100,000 annuity from Company B she will owe income tax on the gain of $50,000. With a 1035 exchange, Lauren can exchange her current annuity for Company B’s annuity without owing taxes on the gain. Her cost basis in Company B’s new annuity contract is the same as her previous basis in Company A’s contract of $100,000.
Gift Tax Annual Exclusion
The law permits the donor to make this type of gift without tax by excluding the first $18,000 of outright gifts in any one specific year to any one recipient. This $18,000 annual exclusion applies to gifts made to each recipient, irrespective of the number of people who receive gifts from the same donor in the same calendar year.
Present Interest
The annual exclusion is available only when the gift is one of a present interest. A present interest is a situation in which the recipient must have possession or enjoyment of the property immediately. An example is a gift of cash or property that can be used immediately by the recipient.
Gift–Splitting
When a married individual makes a gift to someone other than a spouse, it is regarded as made one-half by each spouse. This privilege of splitting a gift when made to a third party is extended only to property given away by a spouse. The taxpayer in such a situation is given the advantage of doubling the annual exclusion that is available for each spouse.
Medical Insurance Benefits
For the self-employed, the premium is deductible in arriving at AGI but not to exceed the taxable income being reported. For example, if John has $10,000 of self-employment income and pays $6,000 in medical insurance premiums, the $6,000 would be deducted in arriving at AGI. However, if the premiums amounted to $12,000, only $10,000 is deducted in arriving at AGI and the remaining $2,000 would be a Schedule A medical deduction.
