Taxation, Retirement Plans and Business Uses of Life Insurance
Taxation
Life insurance taxation
Death benefits paid to a named beneficiary are generally income-tax free. The estate tax result is separate: proceeds may be included in the insured's estate if the insured held incidents of ownership, such as the right to change the beneficiary or borrow against the policy. Cash value grows tax-deferred, and policy loans are generally not taxable while the policy remains in force, but unpaid loans reduce the death benefit and can cause a lapse with taxable gain. Premiums for personally owned life insurance are generally not deductible. Group term life coverage above $50,000 creates imputed income for the employee. A modified endowment contract (MEC) loses some tax advantages: loans and withdrawals are taxed first as gain and may incur a 10% penalty before age 59 1/2.
Health and disability
Employer-paid health premiums are generally tax-free to employees, while individually paid premiums may be deductible only within medical-expense or self-employed rules. Disability benefits are taxable to the employee if the employer paid the premiums; benefits are generally tax-free if the employee paid with after-tax dollars.
Trap and rule
A policy loan is not automatically tax-free forever; it is tax-free only while the policy stays in force. If the policy lapses or is surrendered with an outstanding loan, the gain can become taxable.
Retirement Plans and Business Uses of Life Insurance
Retirement plans
Qualified plans receive favorable tax treatment in exchange for rules on eligibility, vesting, funding, and nondiscrimination. Defined-benefit plans promise a benefit, usually based on salary and years of service; defined-contribution plans specify contributions, not a guaranteed benefit. Common examples include 401(k), 403(b), SEP, and SIMPLE plans. Traditional IRA and 401(k) contributions are often pre-tax, with withdrawals taxed as ordinary income; Roth contributions are after-tax, and qualified withdrawals are tax-free. Distributions before age 59 1/2 may incur a 10% penalty unless an exception applies. Required minimum distributions apply after the account owner reaches the applicable age under current law. ERISA sets fiduciary and reporting standards for many employer plans.
Business uses
Life insurance supports business continuation and compensation planning. Key-person insurance compensates a business for the loss of a critical employee; the business owns the policy and is the beneficiary. In a buy-sell arrangement, life insurance funds the purchase of a deceased owner's interest. The arrangement can be an entity purchase (the business buys the interest) or a cross-purchase (other owners buy it). Split-dollar and deferred compensation plans can provide executive benefits, but they must be structured carefully. Group life provides basic coverage and may be supplemented by individual policies.
Traps and rule
Do not assume all retirement contributions are deductible or all withdrawals are tax-free. Match the tax character to the plan. For a buy-sell, confirm who owns the policy and who receives the proceeds; that determines whether the money can fund the purchase.