CHAPTER 8 TAX CONSIDERATIONS

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1 CHAPTER 8 TAX CONSIDERATIONS Life insurance traditionally has enjoyed favorable tax treatment. The major advantages are (1) the death benefits of a life policy payable to a beneficiary are not subject to federal income tax or California state income tax and (2) the accumulation of cash values in a permanent policy grow tax deferred. The death proceeds of a life policy are paid directly to the beneficiary and are not subject to probate unless the proceeds are payable to the insured s estate. To keep people from buying life insurance as an investment rather than for its protection, policies must conform to the definition of life insurance found in Section 7702 of the Internal Revenue Code. A life policy must conform to either the cash value accumulation test or the guideline premium and corridor test. The cash value accumulation test states that the cash surrender value of the policy cannot exceed the net single premium that would be needed to fund future benefits (the net single premium for a policy of the same face amount must be more than the accumulated cash value). The corridor test states that the cash value of a life policy cannot account for more than a certain percentage of the total death benefit. A policy will conform to the guideline premium test if the total premiums paid do not exceed the greater of the guideline single premium (the total premium paid at one time to fund future benefits) or the total of the guideline level premiums (the level annual amount payable to at least the insured s 95 th birthday to fund future benefits). When a life policy fails to meet one of these tests, the earnings in the policy may be taxable to the policyowner as income in the year earned and only the pure insurance part of the death benefit (face amount minus cash value) will be paid to the beneficiary tax free. LIFE INSURANCE PROCEEDS PAID UPON DEATH When an insured dies, the life insurance proceeds paid in a lump sum to the beneficiary are not subject to federal and California state income tax. This also is true if additional benefits are paid by an accidental death rider or from the dividend option of paid-up additions. However, if a settlement option is selected, part of the payment will be tax free and part will be taxed. The principal amount from the death benefit is not taxed, but the interest paid on this amount is taxable to the beneficiary. If the interest only settlement option has been selected, all the interest payment is taxable to the beneficiary. When the beneficiary eventually receives the principal sum, it will not be taxed. If the insured had picked the accumulate at interest dividend option, that amount would be paid to the beneficiary along with the death proceeds. The dividend is not taxable but any interest payable would be subject to taxation. Death proceeds from a group policy paid to a beneficiary are received income tax free in the same manner that individual policies are treated. 1

2 TRANSFER FOR VALUE RULE If a life policy is transferred by assignment for valuable consideration, the new owner will be taxed on the death benefit in excess over the consideration paid plus any premiums paid. This is the case when a viatical settlement company buys a policy at a discounted face amount. The gain the viatical company realizes is subject to taxation. This rule does not apply to transfers between a policyowner and an insured, transfers to a partner of an insured, transfers to a corporation in which the insured is an officer or a stockholder, or transfers of interest made as a gift. CASH SURRENDER VALUE If a policyowner were to cash surrender the policy, some of the cash value received may be subject to ordinary income tax. Only the amount in excess of the cost basis will be taxed. The cost basis is the total premium paid, less dividends paid, less any policy loan, and less extra premium paid for riders such as accidental death or waiver of premium. ACCELERATED BENEFITS Accelerated or living benefits paid by a life policy are treated in the same manner as death benefits. These benefits are received income tax free if the insured is terminally ill and is expected to die within 12 months or the benefits are used to pay for long-term care due to the insured s chronic illness EXCHANGE When a person realizes a gain on a financial transaction, it will be subject to taxation. However, in accordance with Section 1035 of the Internal Revenue Code, if a life policy is exchanged for another like-kind policy, there is no current gain or loss. Therefore, the exchange is not subject to any tax. The kinds of transactions that are allowed under this provision include: A life policy for another life policy A life policy for an annuity contract An annuity contract for another annuity contract POLICY LOANS A policyowner who has a permanent policy with cash value has the right to borrow against the policy. The amount of the loan is not subject to taxation. However, the insurance company will charge the policyowner interest on the loan. This interest charge is necessary as the insurer made the assumption that 2

3 the cash value would be maintained in the contract and that the insurer could invest the money and realize an investment return. Modified endowment contracts (MECs) were discussed in Chapter 3. It should be remembered that the living benefits of a MEC receive different treatment. Money borrowed from a MEC is considered to come first from earnings (excess of cash value over cost basis) and will be taxed as ordinary income. If these distributions are paid to a policyowner before age 59½, there will be a 10% penalty in addition to the regular income tax. DIVIDENDS Dividends paid on participating policies issued by mutual companies are not taxed. The government regards dividends as a return to the policyowner of excess premium charged. However, if the policyowner picked the accumulate at interest dividend option, the interest is taxable in the year earned. ANNUITY PAYMENTS Part of an annuity payment is taxable and part is not taxable. Part of each payment is considered return of capital and is not subject to taxation. The remainder of the payment is considered return on investment and subject to taxation. Once the capital has been recovered during the course of payments, the entire annuity payment is taxable at ordinary tax rates. The taxable income of an annuity is based on an exclusion ratio. This is a ratio of the amount invested in the contract to the total expected return on the contract based on average life expectancy tables. Investment in the contract Expected return on contract = Exclusion Ratio If a person had invested $50,000 in an annuity contract and based on his/her age the insurer determined it would pay out $100,000 under this contract, the exclusion ratio would be: $ 50,000 = 1/2 $100,000 Therefore, if the annual payment were $6,000, one half would be excluded from taxation. $3,000 would not be taxable and $3,000 would be taxable. PREMIUMS Premiums paid for individual life insurance policies are considered to be personal expenses and are not tax deductible. When a business buys insurance 3

4 to perpetuate the continuation of the business, premiums are not tax deductible. Instead such premiums are considered to be a capital investment. If a company provides group term life insurance for its employees, it is a deductible expense for the company. If a company were to purchase group permanent life insurance, the employer contributions are treated as taxable income to the employee. There are certain circumstances when premiums are tax deductible. These include: Premiums paid by an employer for group term life insurance, disability income insurance, and health insurance. When the policy is owned by a qualified charitable organization. When premiums are paid by a business creditor for life insurance purchased as collateral for a debt. When the premiums are paid by an ex-spouse as part of alimony making it deductible as part of alimony payments. CHARITABLE USES OF LIFE INSURANCE There are two ways in which to make charitable gifts of life insurance. The first is to make an outright gift of the life policy to the charity. In this case the charity becomes the owner and beneficiary of the life policy and the original policyowner making the gift gives up all incidents of ownership in the policy. The policy cash values are generally deductible as a charitable donation on the part of the original policyowner. The person gifting the life policy also may choose to continue making the premium payment on behalf of the charity. Again the amount of the premium payments is generally tax deductible. If a policyowner makes a charity the beneficiary of the life policy but retains the ownership of the policy, no tax deductions are allowed. The proceeds of the policy are part of the owner s estate but will be considered a charitable deduction when the estate is settled. FEDERAL ESTATE TAX Federal estate tax is levied on the value of property transferred by a person upon death. The tax is not imposed upon the person receiving the property but rather upon the estate of the deceased party. All of the property owned by the deceased will be taken into account including life insurance policies. The Tax Relief, Unemployment Insurance Authorization and Job Creation Act of 2010 provided major changes to the federal estate tax rules and rates. For 2012, each person can leave a $5.12 million estate tax free with amounts over $5.12 million taxed at a federal rate of 35%. A couple could leave up to $10.24 million without estate taxes. Many states impose a separate estate or inheritance tax that can cause the combined state and federal tax rate to 4

5 approach 50%. This law is only in effect until the end of On January 1, 2013 this law will sunset and only $1,000,000 can be passed tax free with any excess taxed at federal rates from 41% to as high as 60% Life policies can represent a large portion of a deceased s estate. If the beneficiary of the policy is the deceased s estate or if the deceased owned the policy on his/her own life, the policy will be included in the property subject to estate tax. If the deceased did not own the life policy on his/her life, it would not be included in the estate. A policyowner might wish to transfer the ownership of a life policy in order to remove it from the value of the estate. However, there is a three-year rule. If the policy is transferred in the three years prior to the insured s death, it still will be included in the estate. Transfer of ownership must take place three years prior to death to remove it from the estate for estate tax purposes. Another way to reduce the value of an estate is to make gifts during one s lifetime. A person (donor) may gift up to $13,000 a year to any number of donees (the receiver of the gift) and not incur a gift tax. Both a husband and wife can gift $13,000 a year to a donee effectively doubling the annual exclusion to $26,000 a year. The Tax Relief Act of 2010 has changed the lifetime gift tax exemption to $5,000,000. Gifts greater than this amount will be taxed. The taxed is levied on the donor and not the donee. An individual may wish to gift a life policy to a donee. The donor will not have a gift tax liability unless the replacement value, which is usually equal to the cash value, is greater than $13,000 ($26,000 for husband and wife). A person may want to gift the life insurance premium to another person. As long as the premium payment plus any other gifts given to the donee in one year do not exceed $13,000 ($26,000 for husband and wife), it will not be subject to gift tax on the part of the donor. REVIEW QUESTIONS 1. Proceeds from a life insurance policy: A. Become a tax liability for the beneficiary. B. Are never subject to any taxation. C. Are received by the beneficiary without the beneficiary having a tax liability. D. None of the above. 2. Which of the following is not subject to taxation? A. Exchanging a life policy for another life policy. B. Exchanging a life policy for an annuity contract. C. Exchanging an annuity contract for another annuity contract. D. All of the above are not subject to taxation. 5

6 3. When a policyowner takes out a loan against the cash values in a policy, it is a taxable event. A. True B. False 4. Are there any tax implications when a policyowner surrenders a permanent policy? A. There never are any taxes due upon surrendering a life policy. B. The entire cash value will be subject to taxation when received. C. Only beneficiaries pay taxes, not policyowners. D. The amount in excess of the cost basis is subject to taxation 5. Which of the following dividend options may have some tax implications? A. One-year term B. Reduce premium C. Accumulate at interest D. Cash 6. Premiums paid for a person s individual life policy may be deducted from his/her income tax. A. True B. False 7. One way to reduce an estate is to make gifts of money. Which of the following is correct? A. A husband and wife together may make gifts totaling no more than $13,000 to any one individual in a year. B. Gifts of money always are taxable to the donee in the year received. C. A husband and wife each may make gifts of money up to a specified amount yearly to whomever they choose. D. Tax regulations do not address the gifting of money. 6

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