Taxation of Life Insurance and Annuities
Taxation of Life Insurance and Annuities
This domain tests federal income, estate, and gift tax treatment of life insurance and annuities. The exam focuses on death benefits, cash-value growth, policy loans, modified endowment contracts, annuity withdrawals, and exchanges.
Core rules
- Death benefits are generally excluded from gross income under IRC §101(a), but the proceeds may be included in the insured’s estate if the insured held incidents of ownership. Premiums may be gifts if ownership is transferred.
- Cash-value growth inside a life policy is tax-deferred. Policy loans are generally not taxable while the policy remains in force; a lapse or surrender with outstanding loans can create taxable gain.
- A modified endowment contract (MEC) fails the 7-pay test. MEC distributions are taxed income-first (LIFO), and a 10% penalty generally applies before age 59½, with exceptions.
- Annuity earnings are tax-deferred. Nonqualified annuity withdrawals are generally taxed LIFO until basis is recovered, and a 10% early-withdrawal penalty may apply before 59½.
- IRC §1035 permits tax-free exchanges of life insurance, annuities, and certain endowment contracts into like-kind contracts, subject to basis carryover and reporting.
Worked example
A client owns a nonqualified annuity with a $100,000 basis and a $150,000 account value. She withdraws $30,000 at age 45. Because annuity withdrawals are generally income-first, the $30,000 is taxable gain, not a tax-free return of basis. A 10% penalty may also apply unless an exception fits. If she had exchanged the annuity under §1035 instead of withdrawing, the gain could remain tax-deferred, but the new contract’s basis and surrender charges would need review.
Traps
Do not say all death benefits are always free of estate tax. Do not treat policy loans as always tax-free; lapse can trigger gain. Do not apply pro-rata taxation to nonqualified annuity withdrawals; the default is LIFO. Do not assume any exchange qualifies under §1035.