Life Insurance Taxes

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Tax Issues

Generally, life insurance proceeds are received federal income tax-free if taken in a lump sum. This is true whether the policy is an individually owned contract or a business owned' policy. Thtis, a beneficiary pays no federal income tax on life insurance proceeds and neither does a corporation.

The basic concept is that the principal (face amount) is returned tax free. However, the installment received is part principal and part interest. Therefore, the interest portion of - the installment is taxable - All interest is taxable as income.

Federal estate tax is a tax on the transfer of property upon the death of an individual, and may range from 0 percent to 55 percent of the adjusted growth estate. Life insurance proceeds are subject to inclusion in the deceased's estate for federal estate tax purposes if:

• the estate was the named beneficiary
• the deceased was the policy owner
• the deceased transferred the policy to another person within three years of death

Thus, a corporate-owned life insurance 4'olicy on the company's president with the corporation as the president's beneficiary would not be included in the deceased president's estate since the corporation was the owner and beneficiary.

Taxes and Life Insurance Premiums

When businesses buy life insurance to perpetuate the continuation of the business, the premiums are considered to be a capital investment and-for this reason-not deductible. However, when a business buys group term insurance for its employees, premiums are generally considered a necessary business expense and are deductible. Employer contributions for permanent life insurance are treated as taxable income of the employee.

Premiums paid for life insurance are generally not tax deductible. For individuals, they are consipered a personal I expense and therefore not deductible.

Minimum DepQsit Insurance

Minimum deposit life insurance is a high cash and loan value whole life form, usually offering a loan immediately upon payment of the first premium (instead of at 'the end of the first year). Such policies were devised in the late 1950s to take advantage of the fact that, at the time, Internal Revenue allowed the interest paid .~m a policy loan to be deducted in full for income t~ purposes. Since that time, however, Internal Revenue has placed restrictions on the interest deduction when the loan is to finance insurance so that the popularity of the form has diminished.

A third party ownership arrangement usually offers a tax advantage to the insured person. If the insured person has no incidence of policy ownership, then the proceeds would not be included in his or her estate-thereby possibly reducing the federal estate tax liability.

Life insurance proceeds may not be exempt from income taxes if the benefit payment results from a transfer for value. If the benefits are transferred under a beneficiary designation to a person in exchange for valuable consideration (whether it be money, an exchange of policies, or a promise to perform services), the proceeds would be taxable as income.

Taxation under the transfer for value rules does not apply to an assignment of benefits as collateral security, because a lender has every right to secure the interest in the unpaid balance of a loan. Nor does it apply to transfers between a policy owner and an insured person, transfers to a partner of an insured, transfers to a corporation in which the insured is an officer or stockholder, or transfers of interest made as a gift (where no exchange of value occurs).

The Effects of Surrender

If a policy owner surrenders the policy for its cash value, some of the cash value received may be subject to ordinary income tax if it exceeds the sum of the premiums paid for the policy (this is known as the Cost Recovery Rule).

Example: Mary surrenders her whole life policy and receives $5,000 in cash. Total premiums paid into the policy were $4,700. Mary owes federal income tax on $300.

Dividends are considered to be a return of excess premium paid by the policy owner. They are not included as income for tax purposes. However, interest earned on dividends and accumulated by the insurance company or paid to the policy owner is taxable in the year received.

In November 1988, Congress passed the Technical and Miscellaneous Revenue Act (TAMRA) which makes any withdrawal, loan, or collateralizing of the cash in certain policies taxable. In order to avoid the taxation and subsequent penalties, the policy owner must limit his or her investment according to the seven pay test established by the government, which limits the amount that may be paid into the policy during the first seven policy years. This information should be provided to a policy owner by his or her:jnsurance company.

Endowment Policies and Annuities

Part of an endowment or annuity payment is taxable and part is not. The nontaxable portion is the expected return of th~ principal paid in. The taxable portion is the actual amount . of payment minus the expected return of the principal paid in. Since these amounts would be difficult to calculate, the IRS makes up tax tables for this purpose.

The taxation of annuity contracts is based upon an exclusion ratio. The exclusion ratio is the relationship of the total investment in the contract (cost base) to the total expected return under the contract (calculated based on average life expectancy tables). This ratio (expressed in a percentage) shows how much of each annuity payment is taxable, and how much is not.

Once an annuitant recovers his or her cost base during the annuity period, the total payments received will be taxed at ordinary income tax rates.

If an annuitant dies and the balance of a guaranteed amount is paid to a beneficiary, the payment is not taxable as income until the investment in the contract has been received tax free (the amount received by the beneficiary is added to the tax free amounts received by the annuitant, and only any amount which exceeds the total amounts paid in will be taxable).

If an endowment is paid as a death claim in a lump sum, the benefit is not subject to income tax.

If an annuitant dies and payments continue to a surviving .' annuitant under a joint and survivor annuity; the same percentage that was excludable before the first annuitant's death will continue to be excluded from taxes.

When a corporation owns a deferred annuity contract as an investment, it is usually not treated as an annuity contract for several purposes-all income and gains received or accrued during a tax year are taxed as ordinary income. This does not apply to annuities which are owned by a corporation for the purposes of funding pension plans, profit plans, and other plans which are treated differently under the tax laws.

There are special tax requirements for modified endowment contracts, including retirement income or semiendowments. In a retirement income endowment policy; the amount payable upon survival (of the endowment period) is greater than the face amount, or cash value. The semiendowment pays, upon survival, one half the sum payable if the insured dies during the endowment period. Because the investment return may be greater than the amount invested, the tax considerations can be complicated.

Estate Tax Issues

Whether the life insurance proceeds will actually be taxed in accordance with federal and state tax laws will be dependent on the deceased's estate status. There are deductions and exemptions which may be applied to adjust a person's estate for tax purposes.

Since 1916, the federal government has levied a tax against the estate of any individual who has recently died. Currently, the maximum amount of that tax is ftfty percent. One exception to this is the marital deduction. An entire estate may be left to a surviving spouse with no tax consequence.

On the business side, Section 303 stock redemption is a special strategy which permits a corporation to partially redeem a shareholder's stock for purposes of providing cash to cover estate settlement costs. Tax laws generally require that stock redemptions be totalled to avoid taxing the proceeds payable to the family as a dividend. The Internal Revenue Service will permit a partial redemption by the corporation to pay funeral expenses, taxes and related estate settlement costs.

Estate planning techniques, such as the use of trusts and gifts, can also reduce the size of a person's taxable estate.

Tax and Group Life Policies

A variety of special tax rules apply to life insurance products which are provided as benefits to employees. Generally, the cost of the first $50,000 of group term life insurance coverage provided to an employee by an employer is not taxable to the employer. The cost of life insurance coverage in excess of $50,000 is taxable as income to the employee. To the extent that an employee is taxed on the cost for incidental life insurance protection, the employee only pays a tax on the cost for pure protection.

For cash value insurance, the taxable cost would be the one year term rate for the amount of protection at risk (face value minus accumulated cash value), regardless of the premium actually being paid by the plan. For term insurance protection, the entire actual cost for protection would be taxable to the employees, because that is the cost for pure protection.

Deferred compensation is an executive benefit which enables a highly paid corporate employee tod~fer current receipt of income such as an executive bonus and have it paid as compensation at a.Jater date (retir~ment, death or disability) when-presumably-the employee will be in a lower tax bracket. Generally, the~employee will enter into an agreement with !he employer which specifies t:l;te amount of monfY to be paid, when it will be paid and the conditions under which the deferred compensation may not be paid.

The agreement will specify that the amount deferred will be paid as a retirement benefit or in the event of the premature death or disability of the employee. It will further indicate that the individual will forfeit the right to this sum of money if he or she leaves the employer except for retirement, death or disability.

The advantage of this agreement for the employee is avoidance of current taxation since receipt of the money is deferred. This is allowed by IRS Section 457. However, there are some disadvantages. Usually, deferred compensation is a nonqualified plan and, as such, it may be funded or unfunded.

Another use of life insurance. is for charitable. purposes. In accordance with tax laws, a policy owner may purchase a life insurance contract on his or her life, pay the premiums and designate a charitable organization as the beneficiary, such as a church, school, hospital or similar organization. Generally, the premium paid by the insured-donor is tax deductible.

Conclusion

If insurance proceeds are included in an estate, they increase the value of the estate subject to taxation. When choosing an amount of insurance to protect your estate, it is important to have a basic understanding of how taxation may affect your life insurance. This chapter discussed a few reasons why it is important to consider taxes when purchasing a life insurance policy.