Federal Tax Considerations for Life Insurance and Annuities
Life insurance taxation
Death proceeds are generally received income tax free. Cash value growth is tax deferred - not tax free - because the inside build-up is not taxed annually. Policy loans are not taxable events while the policy remains in force; they become taxable if the policy lapses or is surrendered with a loan exceeding basis. Dividends are a return of premium and are not taxable until they exceed total premiums paid. On surrender, the gain is proceeds minus basis (premiums paid less dividends and prior withdrawals).
MECs and transfers
A modified endowment contract (MEC) results when a policy fails the 7-pay test (overfunded relative to a level 7-pay premium). MEC distributions are taxed LIFO - gain first - and a 10% penalty applies before age 59½, similar to annuities. The transfer-for-value rule makes death proceeds taxable to the buyer when a policy is sold, with exceptions for the insured, a partner of the insured, a partnership in which the insured is a partner, or a corporation in which the insured is a shareholder. Section 1035 exchanges roll life to life, life to annuity, or annuity to annuity tax free - but not annuity to life.
Estate, business, and other rules
Proceeds are included in the insured's gross estate if the insured held incidents of ownership at death (or transferred them within 3 years of death). Employer-paid group term life over $50,000 creates imputed income; premiums for personally owned coverage are not deductible, while employer premiums are deductible business expenses.
Disability and health
Personally paid disability premiums are not deductible, so benefits are tax free; employer-paid disability premiums are deductible, so benefits are taxable. Employer-paid health premiums are deductible and the benefit is tax free.
Traps: assuming cash value is tax free; forgetting the 10% penalty on MEC and annuity distributions before 59½; and missing that an annuity-to-life-insurance exchange is not a valid 1035 exchange.
Rule of thumb: death benefit = income tax free; living withdrawals = tax deferred until basis is recovered.