Federal Tax Considerations for Life Insurance and Annuities
Life insurance taxation
A death benefit paid to a named beneficiary is generally income-tax free. Cash value grows tax deferred, and policy loans are not taxable while the policy stays in force - but if the policy lapses or is surrendered with an outstanding loan, the gain can become taxable, and a surrender is taxed to the extent the proceeds exceed basis. Premiums are not deductible for an individual. Dividends are treated as a return of premium until basis is recovered.
MEC rules
A policy that fails the seven-pay test becomes a modified endowment contract. A MEC keeps the tax-free death benefit, but lifetime distributions - including loans - are taxed gain first, and a 10% penalty applies before age 59½ unless an exception (disability, death, annuitization over life expectancy) applies.
Annuities taxation
Annuity growth is tax deferred. Payments under a nonqualified annuity are taxed using the exclusion ratio: the investment in the contract divided by the expected return gives the tax-free percentage of each payment; once basis is recovered, everything is taxable. Withdrawals before annuitization are taxed LIFO - gain first - and a 10% penalty applies before 59½ with limited exceptions. A 1035 exchange moves a life policy or annuity to a like-kind contract without current tax. The transfer-for-value rule makes a transferred policy's death benefit taxable to the buyer unless an exception (insured, partner, corporation, or certain family transfers) applies.
Estate, gift, and business
Life proceeds are included in the insured's gross estate if the insured held incidents of ownership at death. Gift tax may apply when an owner gives away a policy. Business uses include key person coverage, buy-sell funding, executive bonus (deductible to the business, taxable to the employee), and split-dollar arrangements. Employer-paid group term life over $50,000 creates imputed income, measured by the IRS Table I rates.
Rule of thumb
Ask two questions: who paid the premium, and did the owner have control? Those two facts drive income tax, estate inclusion, and benefit taxability in almost every question.