Tax treatment of life insurance premiums, proceeds, and MECs

The big picture

Life insurance gets favorable federal tax treatment, and that treatment comes from the Internal Revenue Code, not from state insurance law. Texas law in Title 7 of the Insurance Code governs how policies are written, delivered, and administered; the tax consequences of premiums, cash values, and proceeds are set by federal statute (26 U.S.C.; Tex. Ins. Code Title 7).

Premiums going in

Premiums on personal life insurance are paid with after-tax dollars — they are a personal expense and are not deductible. The Code also denies a deduction for premiums paid on a policy covering any officer, employee, or person financially interested in the taxpayer's trade or business when the taxpayer is directly or indirectly a beneficiary (26 U.S.C. § 264). One notable exclusion on the employee side: for employer-provided group term life insurance, the cost of coverage up to $50,000 is excluded from the employee's income, and the cost of coverage above that amount is includible (26 U.S.C. § 79).

Cash value while the policy is in force

So long as the contract meets the statutory definition of a life insurance contract — the cash value accumulation test or the guideline premium and cash value corridor test — the internal growth of cash value is not currently taxed (26 U.S.C. § 7702). This is often called tax-deferred inside buildup.

Death proceeds

Amounts received under a life insurance contract paid by reason of the death of the insured are excluded from gross income (26 U.S.C. § 101(a)). Points to remember:

• If proceeds are held and paid later, or paid as installments, the interest element is taxable even though the principal remains excluded.
• Under the transfer-for-value rule, if a policy is transferred for valuable consideration, the exclusion is limited to the consideration paid plus later premiums — unless the transfer falls within an exception, such as a transfer to the insured, to a partner of the insured, to a partnership in which the insured is a partner, to a corporation in which the insured is a shareholder or officer, or a carryover-basis transfer (26 U.S.C. § 101(a)(2)).
• Accelerated death benefits paid to a terminally ill insured are treated as paid by reason of death; chronically ill payments are excludable subject to statutory limits (26 U.S.C. § 101(g)).
• Income-tax free is not estate-tax free: proceeds are included in the insured's gross estate if the insured possessed incidents of ownership at death or the estate is the beneficiary (26 U.S.C. § 2042).

Living distributions from a policy that is not a MEC

• Withdrawals and dividends come out on a cost-recovery (FIFO) basis — tax free up to the investment in the contract, then taxable.
• On surrender, gain equals the amount received over the investment in the contract and is ordinary income.
• Policy loans are not taxable while the contract stays in force, but a lapse or surrender with a loan outstanding can produce taxable gain.
• A like-kind exchange of life policy for life policy or for an annuity is generally nontaxable (26 U.S.C. § 1035).

Modified endowment contracts

A contract entered into or materially changed after June 21, 1988 that meets the definition of life insurance but fails the 7-pay test is a modified endowment contract, or MEC (26 U.S.C. § 7702A). The 7-pay test is failed when cumulative premiums paid at any time during the first seven contract years exceed the sum of the net level premiums that would have been paid on a seven-year paid-up policy. Overfunding a policy is what creates a MEC.

Once a contract is a MEC, the living money changes character:

• Distributions are taxed LIFO — income first, then basis.
• Loans, pledges, and assignments are treated as distributions, so borrowing can trigger tax.
• A 10% additional tax applies to the taxable portion unless the taxpayer is age 59½ or older, is disabled, or the payment is part of a series of substantially equal periodic payments (26 U.S.C. § 72(e), (v)).

The death benefit of a MEC is still excluded from gross income under § 101(a). MEC status affects living distributions, not death proceeds. MEC status is permanent, and it follows the contract through a § 1035 exchange.