Taxation of Life Insurance & Annuities

Life Policy Taxation -

Premiums & Cash Value

> Premiums paid for individual life insurance are with after-tax dollars and are NOT deductible for income tax purposes

> Cash Value (Account Value for ULs) growth NOT taxable as long as policy remains in force

Life Policy Taxation -

Cash Surrender & Maturity Values

Cash Surrender and Maturity Values are taxable to the extent there is a gain in the policy.

Example: If a policy's cash surrender value is $100K and premiums of $60K have been paid in (i.e. cost basis), then $40K ($100K - $60K) of cash surrender value will be taxed as ordinary income to the policy owner.

Life Policy Taxation -

Death Benefit Proceeds

- Death benefit paid to beneficiary is received free of federal income taxes.

- However, if beneficiary receives policy proceeds as part of a settlement option other than lump sum, the portion of any payment that represents interest earned WILL be taxable to beneficiary.

Life Policy Taxation -

Policy Dividends

- Generally, since policy dividends are a return of premium (after-tax dollars) they are NOT taxable.

- However, any interest earned on dividends left with the insurance company will be taxable to the policyowner (e.g. Accumulate @ Interest dividend option).

1035 Exchange

A provision in the Internal Revenue Code that allows for the exchange of cash value from one life policy or annuity to another, while preserving the original policy's tax basis and deferring recognition of gain for federal income tax purposes.

Modified Endowment Contract

(MEC)

A special tax qualification given to a life policy that has been funded with more money than allowed under federal tax laws during its first 7 years of being in force (i.e. it has failed the 7-Pay Test)

> Applies to ULs and Single Premium Life policies

> MECs taxed on LIFO basis (vs. FIFO for non-MECs)

7-Pay Test

Test used to determine if cumulative premiums paid in for a life policy during the first 7 years make it qualify as a Modified Endowment Contract (MEC)

Group Life Insurance -

Taxation

- Premiums paid by employer are tax-deductible as business expense by employer

- Death benefit paid to beneficiary is tax-free

- Premiums paid by employer for first $50K of coverage will NOT be taxable to employee. However, premiums paid by employer for coverage amounts over $50K WILL BE taxable to employee and reported as income on employee's W-2

Annuity Taxation -

Annuitant

QUALIFIED ANNUITY

Contributions: Pre-Tax $

Growth/Earnings: Tax-Deferred

Distributions: 100% Taxable

NONQUALIFIED ANNUITY

Contributions: After-Tax $

Growth/Earnings: Tax-Deferred

Distributions: Partially Taxable (see Annuity Exclusion Ratio)

Both: 10% penalty on distributions < 59 ½

Annuity Exclusion Ratio

- Used to calculate non-taxable portions of distributions from non-qualified annuities

Exclusion Ratio = IN (Total Contributions) ÷ OUT (Total Expected Payout)

- Exclusion ratio % is applied to any distributions to determine the % of the distribution that will be excluded from taxation

Annuity Taxation -

Beneficiary

Beneficiaries of an annuity will be responsible for income taxes on it.

The taxation will depend on how the beneficiary takes the annuity benefits (e.g. lump sum vs. annual distributions).