Life Insurance Taxation, Retirement, and Business Uses
How life insurance is taxed
Death proceeds are generally income-tax-free to the beneficiary but are included in the insured's gross estate if the insured held incidents of ownership (or assigned the policy within three years of death). Cash value grows tax-deferred; policy loans are not taxable while the policy stays in force; a surrender is taxed on gain, with a 10% penalty only if the contract is a MEC and the owner is under 59½. Dividends are treated as a return of premiums until basis is recovered. A transfer for value removes the income-tax-free death benefit, except transfers to the insured, a partner, a partnership, or a corporation in which the insured is a shareholder or employee. MEC distributions are LIFO with a 10% penalty before 59½.
Retirement vehicles
Traditional IRA (deductible contributions, taxable withdrawals, required minimum distributions beginning at 73 for those born 1951–1959 and 75 for those born 1960 or later), Roth IRA (after-tax contributions, tax-free qualified withdrawals, no lifetime RMD for the owner), 401(k), 403(b), SEP (employer-funded), SIMPLE (small employers), and nonqualified deferred compensation.
Business uses
Key person insurance indemnifies the business, with premiums nondeductible and proceeds generally tax-free. Buy-sell agreements (entity-purchase or cross-purchase) fund transfer of a deceased owner's interest. Split dollar shares premium and benefit between employer and employee; executive bonus (Section 162) is a deductible bonus the executive uses to buy a personally owned policy. Group carve-out provides individual coverage to select executives.
Worked example: An owner paid $60,000 in premiums and surrenders for $85,000; the $25,000 gain is ordinary income, with no 10% penalty unless the contract is a MEC. Trap: the $50,000 group term exclusion covers only the cost of coverage above $50,000 (Table I), not the whole benefit.