Death benefits under single premium life policies usually are paid free of any federal income tax. In general death benefits paid under these policies are subject to the same federal and state income, estate, gift, and generation-skipping transfer taxation rules as all other types of life insurance policies.
Taxation of Lifetime Distributions and the MEC Rules
Taxation of lifetime distributions and loans from single premium policies generally depends on when the policy was acquired. Policies issued after June 20, 1988 are likely to be MECs; polices issued before June 21, 1988 were “grandfathered,” and are generally not subject to the MEC rules.
Policies issued after June 20, 1988 – Single premium life policies issued after June 20, 1988 are modified endowment contracts (MECs). Under the MEC rules, amounts received under the policy because of surrender or lapse of the policy or as loans from the policy are subject to income tax, to the extent of “gain” in the policy.
Gain in the policy is determined by subtracting the adjusted premium from the policy cash value. In single premium policies, the adjusted premium is generally simply the initial premium paid. The Last-In First-Out (LIFO) method is used to determine whether amounts distributed are gain or return of principal (premium). This means that amounts received under the contract are treated as first coming from income or gain; only when the gain is exhausted are they treated as a return of principal or premium.
Loans secured by the collateral assignment of a single premium policy as well as interest accrued on policy loans are also generally treated as potentially taxable amounts received under the policy. The policyowner will receive an increase in the basis in the policy to the extent that any loan or pledge is taxable.
Dividends paid in cash, as well as dividends retained by the insurance company as principal or interest on a policy loan, are amounts received under the contract and are potentially taxable. Amounts not treated as received under the contract (and, therefore, not subject to tax) include dividends retained by the insurer to purchase paid-up additions or contractually mandated additional term insurance, to acquire other qualified additional benefits, or which are treated as other consideration for the contract.
Any amounts received under a contract that are taxable are also subject to an additional 10 percent tax unless:
- made on or after a taxpayer attains age 59½;
- attributable to a taxpayer becoming disabled; or
- part of a series of substantially equal periodic payments (not less frequently than annually) made for the life (or life expectancy) of the taxpayer or for the joint lives (or joint life expectancies) of the taxpayer and beneficiary. Generally, contracts owned by “nonnatural persons,” such as corporations, are not eligible for these penalty exceptions.
Policies issued before June 21, 1988 – Policies issued prior to June 21, 1988 are “grandfathered” and avoid the MEC rules unless there is a “material change” in the policy. In particular, this means that proceeds from policy loans will not be subject to income tax and that other withdrawals or distributions of cash values before age 59½ will not be subject to the additional 10 percent tax.
A material change is any increase in the future benefits under the contract, with the following exceptions:
- cost-of-living increases that are based on a broad-based index, such as the Consumer Price Index;
- death benefit increases inherent in the policy design due to the crediting of interest or other earnings; or
- death benefit increases necessary to keep the relationship between the death benefit and cash values required to maintain the tax code definition of life insurance under Code section 7702.
In general, grandfathered single premium policies should meet the second or third exception. Therefore, policyowners who own grandfathered policies enjoy a special tax privilege allowing them to borrow from their policies without being subject to LIFO-based income taxes. However, they can lose their grandfathered status if a policy is exchanged for a new policy, or if the face value of the policy is increased in such a way that it is treated as a material change.
A warning is in order regarding the future taxation of single premium policies. Congress has been looking at the tax deferred cash accumulation feature of life insurance as a potential source of additional tax revenues. Although many experts believe cash value life insurance will retain its tax deferred accumulation feature, if Congress acts to discontinue or limit this tax deferral feature, it will be single premium and other limited premium payment, high cash value policies that Congress will most likely target. In the event of tax changes in this area, the likelihood of a grandfather provision for existing policies is uncertain. In the authors’ opinion, existing policies will have possibly only very limited protection. Amounts already accumulated in these types of policies may be grandfathered if and when reforms are enacted, but future accumulations will probably not be sheltered.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM