Limited pay policies that are not classified as Modified Endowment Contracts (MECs) are taxed in the same manner as ordinary level premium whole life insurance. In general, death benefits are subject to the same income, estate, gift, and generation-skipping transfer taxation rules as all other types of life insurance policies.
In summary, life insurance death proceeds are generally paid free of any federal income tax.1 Living benefits are taxed under the rules of Section 72 of the Internal Revenue Code. Under the section 72 rules, annuity payments are treated as part taxable income or gain and part nontaxable recovery of the investment in the contract until the entire investment in the contract has been recovered. After the investment in the contract has been fully recovered, additional annuity payments are entirely taxable as income.
Payments of interest only are generally taxable in full when paid.2 Other amounts not received as an annuity, such as dividend payments, lump-sum cash settlements of cash surrender values, cash withdrawals (if permitted), and amounts received on partial surrender are taxed under the cost recovery rule. That is, these amounts are initially treated as nontaxable recovery of investment in the contract, and, only after the entire investment has been recovered, taxable income or gain.
Policy loans are not treated as distributions. If a policy loan is still outstanding when a policy is surrendered, the borrowed amount becomes taxable at the time of surrender to the extent of gain in the contract.
Policies that fail the seven-pay test will be treated as modified endowment contracts (MECs). In summary, similar to non-MEC policies, death benefits will generally be paid free of federal income taxation6 and the cash value buildup is not subject to current taxation. However, in contrast with non-MEC policies, distributions, including loans (even if the loan proceeds are retained by the company to pay premiums) and dividends that are either paid in cash or retained by the insurer to pay either interest or principal on a policy loan, generally will be taxed under the interest-first rule rather than the cost recovery rule. That is, amounts received are treated first as taxable income to the extent the cash value exceeds premiums paid, and only then as nontaxable recovery of investment in the contract. In addition, taxable amounts are subject to a 10 percent penalty tax unless the distribution is made after the taxpayer becomes disabled, attains age 59½, or the distribution is part of a series of substantially equal periodic payments made for the taxpayer’s life or life expectancy, or the joint lives or life expectancies of the taxpayer and his or her beneficiary.8 Dividends that are retained by the insurer for the purpose of purchasing paid-up additions are not treated as taxable amounts received under the contract.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM