How to Understand the Tax Implications of Variable Life Insurance Policies

Variable Life (VL) and variable universal life insurance products that do not violate the modified endowment contract rules are taxed in the same manner as other types of life insurance policies. Death benefits usually are paid free of any federal income tax. VL and VUL policies are subject to the same income, estate, gift, and generation-skipping transfer taxation rules as all other types of life insurance policies.

The tax rules for living benefits from VL and VUL products also are the same as for living benefits from other types of life insurance policies. The cost-recovery rules of Internal Revenue Code Section 72 govern the taxation of annuity-type distributions. These rules state that policyowners recover their investments in their contracts (generally, total premiums paid less prior nontaxable distributions) ratably over their expected payout periods.

Interest paid on or credited to living benefits held by the insurer under an agreement to pay interest is taxable immediately in full. The cost-recovery rule generally applies for the taxation of all other types of living benefits. The cost-recovery rule, which is sometimes called the First-In First-Out (FIFO) rule, treats amounts received first as a nontaxable recovery of the policyowner’s investment in the contract. Only after policyowners fully recovers their investment are additional amounts they receive treated as taxable interest or gain in their policies. Included in this category of living benefits are policy dividends, lump-sum cash settlements of cash surrender values, cash withdrawals, and amounts received on partial surrender. Policyowners include such amounts in gross income only to the extent such amounts exceed the investment in the contract (as reduced by any prior excludable distributions owners receive from their contracts). In other words, nonannuity distributions during life generally are first treated as a return of the policyowner’s investment in the contract and then as taxable interest or gain.

Reproduced with permission.  Copyright The National Underwriter Co. Division of ALM

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