Federal Tax Considerations for Life Insurance and Annuities
Life insurance taxation
Death proceeds paid to a named beneficiary are generally received income tax free. Inside buildup of cash value is tax deferred and is not taxed unless the policy is surrendered, lapses, or is a modified endowment contract. Policy loans are not taxable while the policy remains in force. Premiums paid by an individual on personal coverage are not deductible. Dividends are tax free until they exceed the owner's cost basis (premiums paid).
Transfer for value and business uses
If a policy is transferred for valuable consideration, the death benefit loses its income tax exclusion except in specific exceptions (transfer to the insured, a partner of the insured, a partnership, or a corporation in which the insured is a shareholder or officer). Employer-owned life insurance under Section 101(j) requires notice and consent.
Modified endowment contracts
A policy that fails the 7-pay test becomes a MEC. Distributions, including loans, are taxed income first (LIFO) and a 10% penalty applies before age 59½, with exceptions for death, disability, and annuitization.
Group life
Employer-paid group term coverage above $50,000 creates imputed income to the employee, computed using IRS Table I rates; employer premiums for coverage up to $50,000 are excluded.
Annuities
Contributions are made with after-tax dollars and are not deductible. At annuitization, the exclusion ratio divides the investment in the contract by the expected return, making that percentage of each payment tax free until basis is recovered; the balance is ordinary income. Lump-sum withdrawals are taxed LIFO with a 10% penalty before 59½. Required minimum distributions generally begin at age 73. 1035 exchanges defer gain when swapping life for life, annuity for annuity, or life for annuity.
Trap: the death benefit is income tax free but may be included in the insured's estate if the insured holds incidents of ownership.