Federal Tax Considerations for Life Insurance and Annuities
Life insurance
Death proceeds are generally received income-tax free under IRC section 101(a) - whether paid as a lump sum or in installments (interest paid in installments is taxable). Premiums are not deductible for an individual, but cash value grows tax-deferred, and policy loans are not taxable unless the policy lapses or is surrendered with outstanding debt. Dividends are treated as a return of premium and are taxable only after exceeding basis. Policies that fail the 7-pay test become modified endowment contracts (MECs): the death benefit is still income-tax free, but lifetime withdrawals and loans are taxed gain-first (LIFO) and a 10% penalty applies before age 59½ on the taxable portion. A transfer for value makes death proceeds taxable to the buyer, with exceptions for a partner, a partnership, or a corporation in which the insured is a shareholder or key person.
Business and estate issues
Employer-paid group term coverage above $50,000 creates imputed income using the IRS Table I rates. Key person premiums are not deductible, and proceeds are generally tax free. In an estate, proceeds are included if the insured held incidents of ownership at death (or transferred them within three years). The unlimited marital deduction can defer estate tax on amounts passing to a surviving spouse.
Annuities
Nonqualified annuity growth is tax deferred; withdrawals before annuitization are taxed gain-first (LIFO) and a 10% penalty generally applies before 59½, with exceptions (death, disability, substantially equal periodic payments, certain medical costs). Once income begins, the exclusion ratio determines the tax-free return-of-basis portion. Qualified plan and IRA distributions are ordinary income; required minimum distributions generally begin at age 73 (later for some birth years), with SECURE Act changes.
Worked example: $100,000 cost basis, $150,000 value - a $50,000 withdrawal is fully taxable and penalized if the owner is 45. Same withdrawal after annuitization over a term would be partly a tax-free return of basis.
Rule of thumb: MEC and nonqualified annuity withdrawals are LIFO; life settlement options paid as interest are taxable as interest.