Federal Tax Considerations for Life Insurance and Annuities
Life insurance taxation
Individual life premiums are not deductible. Cash value grows tax-deferred; withdrawals are generally taxed FIFO (basis first) for life insurance, unlike annuities. Death benefits paid to a beneficiary are generally income-tax free under IRC §101(a) - but not estate-tax free if the insured held incidents of ownership at death (estate inclusion). Policy loans are not taxable while the policy stays in force but become taxable if the policy lapses or is surrendered with outstanding loans exceeding basis. Dividends are not taxed until they exceed the owner's basis. Interest on dividends left on deposit is taxable.
A policy fails the 7-pay test and becomes a modified endowment contract (MEC); MECs lose the FIFO advantage (gain-first withdrawals), and pre-59½ MEC withdrawals may incur a 10% penalty. Transfer for value rules make death benefits taxable to a buyer unless an exception applies (e.g., a partner, a corporation insuring a key person, or a basis carryover transfer). Section 1035 allows tax-free exchange of life-to-life, life-to-annuity, and annuity-to-annuity contracts.
Business and group context
Employer-paid group term life premiums are deductible to the employer and not taxable to the employee on the first $50,000 of coverage; employer contributions to group disability may or may not create taxable benefits depending on whether the benefit is contributory - benefits are taxable to the extent premiums were employer-paid.
Trap: a client asks if a large cash-value loan is taxable - the answer is not while the policy remains in force. Also, death benefits paid in installments include taxable interest.
Worked example: $100,000 basis, $130,000 cash value. Withdrawal of $40,000 from an ordinary life policy is tax free to extent of basis ($40,000 is below basis); the same withdrawal from an annuity creates $30,000 of taxable gain.