The income tax rules for IUL policies are virtually identical to the tax rules for UL policies which are essentially the same as the tax rules for other types of life insurance policies. Beneficiaries receive death benefits that usually are free of any federal, state, and local income tax. IUL 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 IUL 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 then–only after the owner has recovered the entire investment in the contract–as taxable interest or gain.
Being that the equity-indexed interest crediting method is the distinguishing feature of IUL, most policyowners are looking to enhanced cash value accumulations as compared with cash-value accumulations in other types of policies that use conventional interest-crediting methods. Consequently, the exceptions to the cost-recovery tax rule for payments of living benefits under IUL policies and the tax risks associated with IUL policies being classified as modified endowment contracts are especially important tax considerations.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM