Federal Tax Considerations for Life Insurance and Annuities
Death benefits and premiums
Death proceeds paid to a beneficiary are generally income tax free under IRC §101(a), but they are not automatically estate tax free. Proceeds are included in the insured's gross estate if the insured owned the policy or held incidents of ownership at death (§2042); an irrevocable life insurance trust removes them. Individual life premiums are not deductible. Employer-paid group term premiums are deductible by the employer, but coverage above $50,000 creates taxable income to the employee measured by the Table I cost.
Policy values and dividends
Dividends are a return of premium: tax free until cumulative dividends exceed premiums paid, then taxable. Interest credited on dividends or left on deposit is taxable annually. Policy loans are not taxable events unless the policy lapses or is surrendered with a gain. Surrender produces ordinary income to the extent cash value exceeds basis. A modified endowment contract (MEC) arises when a policy fails the 7-pay test; MECs lose favorable loan treatment, and distributions are taxed LIFO with a 10% penalty before 59½.
Section 1035 and transfer for value
A 1035 exchange defers gain on life-to-life, life-to-annuity, and annuity-to-annuity exchanges. Under the transfer-for-value rule, if a policy is sold for consideration the death benefit becomes taxable to the buyer, with exceptions for the insured, a partner of the insured, a partnership, or a corporation in which the insured is a shareholder or executive.
Annuities and accelerated benefits
Annuity earnings are tax deferred; annuitized payments use the exclusion ratio; premature withdrawals may incur a 10% penalty. Accelerated death benefits are generally income tax free for the terminally or chronically ill, subject to per diem limits for long-term care-type benefits.
Trap and rule of thumb
Examiners love the phrase income tax free death benefit - it does not mean estate tax free. Rule of thumb: income tax follows the beneficiary; estate tax follows ownership.