The tax rules for CAWL policies are generally the same as the tax rules for other types of life insurance policies. Death benefit payments are usually free of any federal income tax. CAWL policies are subject to the same estate, gift, and generation-skipping transfer taxation rules as all other types of life insurance policies.
Similarly, the tax rules for living benefits from CAWL policies are also the same as the tax rules for living benefits from other types of life insurance policies. The annuity cost recovery rules of Code Section 72 govern annuity-type distributions. These rules state that policyowners recover their investment in the contract (generally, total premiums paid less prior nontaxable distributions) ratably over the expected payout period.
The “cost recovery rule” for taxation generally applies to all other types of living benefits. The cost recovery rule, which is sometimes called the First-In-First-Out (FIFO) rule, treats amounts received by the policyowner as a nontaxable recovery of the policyowner’s investment in the contract. Only after the policyowner fully recovers the investment in the contract are additional amounts received 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. The policyowner includes such 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, policyowners generally treat nonannuity distributions during life first as a return of the policyowner’s investment in the contract, and then as taxable interest or gain. If the insurer holds any living benefits under an agreement to pay interest, the policyowner must report and pay taxes each year on all the interest the insurer pays on or credits to the living benefits.
Exception to the Cost Recovery Rule
The general cost recovery rule has an important exception for withdrawals within the first fifteen years after the policy issue date that are also coupled with reductions in death benefits. Because the insurer generally reduces death benefits in an amount equal to any withdrawal of cash values, policyowners generally will have to report and pay income tax on the amount withdrawn or distributed to the extent attributable to gain in the policy.
Such withdrawals are taxed in whole or in part as ordinary income to the extent “forced out” of the policy as a result of the reduction in the death benefits. The taxable amount depends on when the policyowner makes the withdrawal:
- Within the first five years – If the withdrawal takes place within the first five years after policy issue, a very stringent and complex set of tests applies. Potentially, a larger portion, or perhaps all, of any withdrawal within the first five years will be taxable if there is gain in the policy.
- Fifth to fifteenth years – For withdrawals between the end of the fifth year and the end of the fifteenth year from the issue date, a mathematical test applies. Essentially, the policyowner is taxed on an income-first basis to the extent the cash value before the withdrawal exceeds the maximum allowable cash value under the cash value corridor test for the reduced death benefit after the withdrawal. Frequently, only a portion or none of the withdrawal will be taxable in these cases.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM