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INCOME TAXATION OF LIVING PROCEEDS OF LIFE INSURANCE

Amounts paid under a life insurance contract while the insured is still living may take one of several forms. The most common of these are policy dividends, withdrawals from the policy�s cash value or investment fund, policy loans, and proceeds from the cash surrender of a policy.

To properly determine the income tax effects of a financial transaction with a policy, the policyowner�s tax basis in the policy must first be known. A policyowner�s basis is initially determined by adding the total premiums paid into the policy and subtracting the dividends, if any, that have been paid by the insurer. If nontaxable withdrawals have previously been made from the policy, such amounts would also reduce the policyowner�s basis. Policy loans generally have no direct effect on basis unless the policy is a modified endowment contract (MEC), discussed later in this chapter. However, it is important to remember that if a policy is surrendered, the principal amount of any loan outstanding against the policy is includible in the surrender value of the policy for tax purposes.

Policy dividends are treated as a nontaxable return of premium and will reduce basis. If total dividends paid exceed total premiums, dividends will be taxable to that extent. If dividends are used to reduce premiums or otherwise paid back into the policy (for example, to buy paid-up additions), the basis reduction caused by the payment of the dividend is offset by a corresponding basis increase when the dividend is reinvested in the policy.

If a policy is surrendered for cash, the taxable amount is the total surrender value minus the policyowner�s current basis in the policy. Dividends left with the insurer to accumulate at interest are not included in the surrender value for tax purposes because they have already reduced the policyowner�s basis in the contract.

 

Example: Mark Sellers, aged 40, owns a level premium whole life policy. Mark has paid $24,000 in premiums and has received $4,000 in dividends from the policy. The face amount of the policy is $100,000. The total cash value of the policy is $28,000. The policy is also subject to an outstanding loan of $15,000. Mark decides to surrender his policy for cash. The tax effects of Mark�s surrender of his policy are as follows:

Surrender Value

Policy loan $ 15,000

Net cash value ($28,000 total value

less $15,000 policy loan) 13,000

Total surrender value $ 28,000

Basis

Premium paid $ 24,000

Minus dividends 4,000

Total basis $ 20,000

Taxable Gain

Surrender value $ 28,000

Minus basis 20,000

Taxable gain $ 8,000

The so-called inside buildup (cash value or investment fund) of a permanent life insurance policy is not subject to taxation as long as it is left inside the policy. Loans from a policy are not taxable unless the policy is a modified endowment contract. If a policyowner withdraws funds from a policy�s cash value, the general rule is that the withdrawal is first treated as a nontaxable return of basis. The excess, if any, of the amount of the withdrawal over the policyowner�s current basis is taxable in the year of withdrawal. However, there are important exceptions to this general rule. These exceptions include certain withdrawals from universal life policies and withdrawals from policies classified as modified endowment contracts.

If a withdrawal is made from a policy that results in a reduction in the policy�s death benefit during the first 15 years of the policy, the withdrawal may first be taxed as income to the extent of income earned within the contract. A death benefit reduction resulting from a cash value withdrawal typically occurs in a universal life contract. This "income first" or LIFO (last in, first out) method of taxation is the reverse of the general rule of "basis first" or FIFO (first in, first out) taxation that life insurance typically enjoys. In addition, unfavorable LIFO tax treatment is the rule with respect to withdrawals and loans from policies that are classified as modified endowment contacts.

Modified Endowment Contracts (MECs)

Any life insurance policy that falls under the definition of an MEC is subject to an income first or LIFO tax treatment with respect to loans and most distributions from the policy. A 10 percent penalty tax also generally applies to the taxable portion of any loan or withdrawal from an MEC unless the taxpayer has reached age 59 l/2. With respect to loans (not withdrawals) from an MEC, the policyowner does receive an increase in basis in the policy equal to the amount of the loan that is taxable. However, as shown in the example below, the nontaxable portion of a loan from an MEC will not affect the policyowner�s basis. A nontaxable portion of a withdrawal, on the other hand, will reduce basis.

 

Example: Assume that Mark Sellers� policy in the previous example is an MEC and that the $15,000 loan from the policy is taken out this year. Mark has a total of $8,000 in untaxed gain in the policy. The loan will first be treated as a distribution of that untaxed gain to the extent of $8,000. The remaining $7,000 of the loan is not taxable to Mark. The $8,000 taxable portion of the loan will also be subject to the 10 percent penalty tax because Mark is under age 59 l/2. Mark�s basis in the policy will be increased by $8,000 (the taxable portion of the loan). Therefore Mark�s basis is now $28,000 ($20,000 + $8,000).

 

A policy will be treated as an MEC if it fails a test called the "7-pay text." This test is applied at the inception of the policy and again if the policy experiences a "material change." A material change generally includes most increases and certain decreases in future benefits under a policy. A common example of a material change is an increase in death benefits under the policy resulting from a flexible premium payment.

The 7-pay test is designed to impose MEC status on policies that take in too much premium during the first 7 policy years, or in the 7 years after a material change. For each policy a "net level premium" is calculated. If the total premium actually paid into the policy at any time during the 7-year testing period is more than the sum of the net level premiums that would be needed to result in a paid-up policy after 7 years, the policy will be an MEC. Stated simply, the 7-pay test is designed to discourage a premium schedule that would result in a paid-up policy before the end of a 7-year period.

There are many specific rules regarding MECs, including effective date and grandfathering provisions, rules designed to prevent certain tax avoidance techniques, and modest relief provisions for certain situations. These rules are quite involved and are beyond the scope of this chapter.

Nontaxable Policy Exchanges

In cases where a policyowner is merely continuing his or her investment in a life insurance or annuity contract by exchanging one contract for another, the tax law provides that the exchange will not result in a taxable event for income tax purposes. This "nonrecognition� provision under IRC Sec. 1035 applies to exchanges of a life insurance contract for another life insurance contract or an annuity contract and to exchanges of one annuity contract for another annuity. Exchanges of annuity contracts for life contracts are not protected by this nonrecognition provision.

If a policyowner takes advantage of the nontaxable exchange provision, his or her basis in the new policy is generally the same as his or her basis in the old policy. If the policyowner receives cash as part of the exchange, the exchange will be partially taxable. The taxable amount is the lesser of the cash received or the untaxed gain in the old policy.

In order for the favorable nonrecognition treatment to apply, both the old and the new contracts must relate to the same insured. Note that losses from the sale, exchange, or surrender of life insurance policies are not deductible in any event.

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