10. Taxation of Life Insurance & Annuities

Income tax treatment

Comes down to two questions:

1. Is the premium tax-deductible?

2. Are distributions taxable?

Are individual life insurance premiums tax-deductible?

No, premiums are taxed.

Are cash values (Interest earnings credited to life insurance) tax-deferred?

Yes, they are not taxable as long as they remain inside the policy.

• Policyowner IS taxed if gain is withdrawn.

What is taxed on a full surrender?

Any “gain” is taxable on a full surrender.

Gain = cash value minus premiums paid.

Are withdrawals or partial surrenders taxable?

Only taxable if there is a gain.

Withdrawals are taxed on a first-in-first-out (FIFO) basis. Money withdrawn comes from premiums paid (cost basis) first—not taxable, and anything over the premiums is considered a gain, and is taxable.

Are cash value loans taxable?

Cash value loans:

• not taxable while the policy is in force.

• if surrendered, only the gain is taxed.

• interest paid on loans is taxable, not tax-deductible

Are dividends taxed?

No, dividends are not taxable. They are considered a return of premium, so you’re not taxed twice.

• interest earned is taxed. If dividends are left to accumulate at interest, interest is taxable while.

Is the death benefit taxed?

Death benefit:

• lump sum = no tax for individual or corporation.

• over time = original death benefit is not taxed, but any interest earned on the proceeds are taxable as ordinary income to the beneficiary.

Are accelerated death benefits taxed?

No, not taxed. Accelerated death benefits are the same tax treatment as regular death benefit.

• critically ill

• terminally ill

Are business life insurance premiums tax deductible?

Taxable for:

• key person.

• policies funding buy-sell agreements.

• policies that will reimburse the company for benefits paid under deferred compensation arrangements.

Tax deferred for:

• executive bonuses (taxable income to the employee)

— death benefits not taxable

Are group life insurance premiums tax deductible?

• Employer paid premiums = tax deductible by employer

• Employer paid premiums for insurance over 50K = taxable income to the employee

• Employee paid premiums = NOT tax deductible by anyone

• death benefit to beneficiary not taxable

What is a Modified Endowment Contract (MEC)?

Life policy that fails the 7-pay test by paying too much premium in the first 7 years.

• flexible premium universal life

• single premium whole life

Withdrawals and loans are taxed interest-first (gain first); the opposite of a non-MEC life policy.

Under 59½, a 10% IRS penalty applies to the taxable portion.

Once a MEC always a MEC

Are annuity premiums tax-deductible?

No, annuity premiums are taxed.

Are annuity accumulations tax-deferred?

Individual annuity = interest during accumulation not taxed/taxable when paid out.

Corporation annuity = earnings are taxable when they are credited.

Are annuity withdrawals taxable?

Yes, during the accumulation period — the withdrawal has the same tax treatment as a MEC.

• interest out first (LIFO)

• income tax on interest

• 10% penalty on interest if younger than 59½

• penalty waived for disability, death, or annuitization

Taxation of annuity payments

• Non-qualified annuities (after-tax money) You already paid tax on the premium. Only the earnings are taxed later.

• Qualified annuities (IRA, 401(k), etc.) The money went in pre-tax (or was deductible). Almost the entire payment is ordinary income.

Annuity payments periodic payments vs. lump sum

Periodic payments are more tax favorable than a lump sum payment.

Annuity payments during annuitization period

• taxed according to the exclusion ratio.

Exclusion ratio = investment in the contract (premiums paid) ÷ expected return.

Each payment has a tax-free piece (return of your premium) and a taxable piece (earnings). Once you have recovered all of the premium, every dollar of the remaining payments is ordinary income.

Annuity distributions at death to a beneficiary

• lump sum - gains are taxable

• five year withdrawal - interest out first, no 10% penalty

• annuity payments - taxed according to the exclusion ratio

• if spouse is beneficiary - transfer ownership to spouse w/ no tax consequences

What is a Section 1035 Exchange?

Section 1035 of the tax code allows individuals to move cash values from one contract to another without having any gain taxed at that time.

• life insurance

• annuities

What are the Section 1035 Life/Annuities that qualify?

• L to L = no penalty

• A to A = no penalty

• L to A = no penalty

• A to L = gains taxed ( does not qualify)

Estate tax treatment: life insurance proceeds

The life insurance proceeds taxes are a % of the estate’s value.

What are the life insurance estate taxes?

Taxes are due on transfer of wealth.

Life insurance death benefits are included as insured’s gross estate if:

• payable to the insured estate

• insured owns the policy at time of death

• insured transferred ownership within 3 years of death

Estate tax treatment: annuities

Estate tax treatment depends on the period when the death occurs.

Accumulation period - entire value of the annuity (including the cost) is included in the estate.

Annuity period - the present value of future payments that will continue to a beneficiary or survivor annuitant is included in the estate.