Tax Considerations of Owning Indexed Universal Life (IUL) Insurance

The income tax rules for UL policies that do not run afoul of the modified endowment contract (MEC) rules are the same as for other types of life insurance policies. Beneficiaries receive death benefits that, usually, are free of any federal income tax. UL policies also are subject to the same estate, gift, and generation-skipping transfer taxation rules as all other types of life insurance policies.

Also, the income tax rules for living benefits paid from UL policies are the same as living benefits paid from other types of life insurance policies. Generally, the cost-recovery rule governs the taxation of these living benefits. The cost-recovery rule, which is sometimes called the First-In First-Out (FIFO) rule, treats amounts received as nontaxable recovery of the policyowner’s investment in the contract. Only after policyowners fully recover their investment in the contract are additional amounts that they receive treated as taxable interest or gain in the policy. 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 these amounts in gross income only to the extent they exceed the investment in the contract (as reduced by any prior excludable distributions received from the contract). In other words, the income tax rules generally treat nonannuity distributions during life first, as a return of the policyowner’s investment in the contract—and only after the owner has recovered the entire investment in the contract—then as taxable interest or gain.

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

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