Life Insurance Taxation
Death benefits
Proceeds paid to a named beneficiary are generally income-tax free. Exceptions include a transfer-for-value, where the purchaser's gain is taxable, and a modified endowment contract (MEC), where proceeds above basis are taxable. Accelerated death benefits for the terminally or chronically ill are also excluded, subject to limits.
Living benefits and cash value
Inside buildup is tax-deferred, and the owner is not taxed on cash value growth or on policy loans while the policy stays in force. Surrender creates ordinary income to the extent proceeds exceed basis (premiums paid less dividends and prior withdrawals), and a lapse with outstanding loan debt above basis creates phantom income. Dividends are a return of premium and are taxable only once cumulative dividends exceed premiums paid.
MEC rules
A policy that fails the 7-pay test is a MEC: distributions are taxed last-in, first-out, and withdrawals before age 59 and a half face a 10 percent penalty. Section 1035 exchanges move values tax-free between like contracts.
Business and estate issues
Employer-paid group term coverage above 50,000 dollars creates imputed income at IRS Table I rates. Business premiums are deductible; individual premiums generally are not, except for charity, alimony under older decrees, and certain business situations. If the insured keeps incidents of ownership, proceeds are included in the gross estate; an irrevocable life insurance trust removes them but requires a three-year wait. Gifts of policies or premiums may use the annual gift tax exclusion.
Worked example
The owner pays 40,000 dollars in premiums, borrows 10,000 dollars, then surrenders for 60,000 dollars. Basis is 40,000 dollars, so 20,000 dollars is ordinary income.
Traps
Policy loans are not always tax free, and death benefits are not always tax free for MECs and transfer-for-value cases.