Tax Implications of Ordinary Whole Life Insurance

Death benefits are usually free of any federal income tax. In general, death benefits paid under these policies are subject to the same income, estate, gift, and generation-skipping transfer taxation rules as all other types of life insurance policies.

Taxation of Living Proceeds

Section 72 of the Internal Revenue Code governs the taxation of living proceeds from life insurance policies. Living proceeds are generally any amounts received during the insured’s lifetime. For tax purposes, payments are separated into three classes: (1) annuity payments; (2) payments of interest only; and (3) amounts not received as an annuity.

Annuity payments – Annuities include all periodic payments received from the contract in a systematic liquidation of the cash value. This includes both life contingent annuities and fixed term or fixed amount annuities. The rules of IRC Section 72 determine what portion of each payment is treated as a tax-free recovery of investment in the contract and what portion is treated as taxable income or gain. To oversimplify, the rules essentially pro rate the recovery of investment in the contract over the expected payout period. Therefore, each payment is treated partially as recovery of investment and partially as taxable interest until the entire investment in the contract has been recovered. Any further payments are treated entirely as taxable income. 

Payments of interest only – Payments consisting of interest only (i.e., they are not part of the systematic liquidation of a principal sum) are not annuity payments and are not taxed under the annuity rules. In general, if living benefits are held by the insurer under an agreement to pay interest, the interest payments are taxable in full when distributed or simply credited to the account.

Amounts not received as an annuity – In general, all living proceeds except for interest and annuity settlements are taxed under the “cost recovery rule.” Included in this category are policy dividends, lump-sum cash settlements of cash surrender values, cash withdrawals, and amounts received on partial surrender. These amounts are included 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, nonannuity distributions during life are first treated as a return of the policyowner’s investment in the contract (generally premiums paid less dividends received), and then as taxable interest or gain.

MEC Rules

The exceptions to this rule are generally unlikely to arise with level premium policies. The first exception is with respect to policies that initially fail the seven-pay test under the Modified Endowment Contract (MEC) rules. Because level premium policies are designed to have premiums payable for the life of the insured, they are not likely to fail the seven-pay test. The second exception is with respect to policies that originally satisfied the tests to avoid MEC treatment, but that as a result of certain changes in the benefits of the contract, subsequently fail the tests. Once again, the types of changes that would jeopardize favorable MEC status are unlikely to arise with ordinary level premium whole life policies. Problems are more likely to arise with limited pay policies and universal life policies. If any life insurance contract is treated as a MEC, cash distributions are generally taxed under the interest-first rule. Under this rule, distributions are first attributed to interest or gain in the contract and are fully taxable. Only when the interest or gain is exhausted are distributions treated as a nontaxable recovery of investment in the contract.

Loan Proceeds

Policy loans under non-MEC life insurance policies 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 the cash value exceeds the policyowner’s investment in the contract. Loans are essentially treated as if the borrowed amount was actually received at the time of surrender and used to pay off the loan.

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

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