The tax rules for AL 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. AL policies also 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 AL 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.
Generally, the cost recovery rule governs the taxation of all types of nonannuity living benefits. The cost recovery rule, which is sometimes called the FIFO (First-In-First-Out) 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 also are coupled with reductions in death benefits. In general, insurance companies do not permit withdrawals from AL policies without a complete or partial surrender of the policy. In other words, to the extent permitted, withdrawals typically will entail reductions in the amount or term of death benefits. Reductions of the face amount or term of coverage could force out some of the cash value under the rules of Code section 7702. If such withdrawals or distributions occur within the first fifteen contract years, the policyowner 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 or distributions 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 distribution takes place within the first five years after policy issue, a very stringent and complex set of tests apply. 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 distributions 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.
Caveat: Potential Taxation under the MEC Rules
The flexibility inherent in AL policies with respect to changes in premiums and face amounts raises the possibility that the policy could become a modified endowment contract (MEC). The penalty for classification as a MEC relates to distributions. If a policy is classified as a MEC, distributions under the contract are taxed under the interest-first rule rather than the cost recovery rule. In addition, to the extent taxable, these distributions are subject to a 10 percent penalty if they occur before the policyowner reaches age 59½, dies, or becomes disabled. So MEC classification of an AL contract means both faster taxation of investment gains and a possible penalty tax for early receipt of that growth.
Distributions under the contract include living benefits (as described above), partial surrenders, policy loans, loans secured by the policy, loans used to pay premiums, and dividends taken in cash. Distributions under the contract generally do not include dividends used to pay premiums, dividends used to purchase paid-up additions, dividends used to purchase one-year term insurance, or the surrender of paid-up additions to pay premiums.
Changes in premiums or death benefits may inadvertently cause an AL policy to run afoul of the MEC rules in basically three ways:
- An increase in premium payments during the first seven contract years may push the cumulative premiums above the amount permitted under the seven-pay test.
- A reduction in the death benefit during the first seven contract years triggers a recomputation of the seven-pay test. The seven-pay test is applied retroactively as of the original issue date as if the policy had been issued at the reduced death benefit.
- A material increase of the death benefit at any time triggers a new seven-pay test which is applied prospectively as of the date of the material change.
When issued, AL policy illustrations show the maximum amount (the seven-pay guideline annual premium limit) that the policyowner may pay within the first seven years without having the policy classified as a MEC. When a policyowner inadvertently exceeds that maximum, the policyowner can avoid MEC status if the insurer returns excess premiums to the policyowner with interest within sixty days after the end of the contract year in which the excess occurs. The policyowner typically will have to report and pay tax on this interest.
A policy will fail the seven-pay test if, in any year, the cumulative premiums paid to that year exceed the sum of the seven-pay guideline annual premiums to that year.
Example. Assume the guideline annual premium is $10,000 based on the original death benefit. The policyowner pays $9,000 each year for the first six years. In year seven, the policyowner reduces the face amount which forces out $18,000 of the cash value. The recomputed guideline premium is $8,000. The policy now fails the seven-pay test and is a MEC because cumulative premiums paid in just the first year, $9,000, (and through year six as well) exceed the sum of the recomputed guideline annual premiums of $8,000. The policyowner will pay tax on the $18,000 to the extent of any gain in the policy. In addition, unless the policyowner is over age 59½ or disabled, the tax law imposes an additional 10 percent penalty on the taxable portion of the distribution.
Any reduction in death benefits attributable to the nonpayment of premiums due under the contract will not trigger a recomputation of the seven-pay test if the policyowner (and insurer) reinstate the prior benefit level within ninety days after being reduced.
The term “material” change is not defined in the statute. However, the statute states that it “includes any increase in death benefit under the contract,” but not increases attributable to dividends (for paid-up additions), interest credited to the policy’s cash surrender value, increases necessary to maintain the corridor between the death benefit and the cash surrender value required by the definition of life insurance, or cost-of-living adjustments. The rules generally consider increases in death benefits that require evidence of insurability as material changes that invoke a new seven-pay test.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM