Federal Tax Considerations for Life Insurance and Annuities
Life insurance taxation
For personal life insurance, premiums are generally not deductible, and the death benefit is generally received free of federal income tax. Cash value grows tax-deferred. Policy loans are not taxable while the policy remains in force, but a lapse or surrender with outstanding debt can create taxable gain. If a policy is surrendered, gain is taxable to the extent proceeds exceed basis. A modified endowment contract, or MEC, loses favorable distribution treatment: withdrawals and loans are taxed income-first, and a 10% penalty may apply before age 59½. The death benefit may be included in the insured’s estate if the insured held incidents of ownership at death.
A transfer-for-value can make death proceeds taxable income to the buyer, with exceptions such as certain business transfers and transfers to the insured. Employer-owned life insurance rules require notice and consent in many cases.
Annuity taxation
Annuity earnings grow tax-deferred. Payments are partly taxable under the exclusion ratio. Withdrawals before annuitization are generally taxable to the extent of gain, and a 10% penalty may apply before age 59½. At death, a beneficiary may face income tax on gains; annuities generally do not receive a step-up in basis.
Traps
Do not say all death benefits are estate-tax free. Do not say policy loans are always tax-free; a lapse can trigger gain. Do not apply life insurance basis rules to annuities without checking the distribution rules.
Worked rule
A MEC distribution is taxed like an annuity: taxable gain comes out first, then basis. A pre-59½ distribution may add a 10% penalty.