Tax treatment of premiums and proceeds

Tax treatment of premiums and proceeds

Almost every insurance sale raises a tax question: Can I deduct what I pay in, and will I owe tax on what comes out? The general federal pattern is easy to remember once you see it as a pipeline — money goes in, it sits and grows inside the contract, and then it comes out through one of several doors. Each stage has its own rule.

Premiums going in

Premiums on personally owned life insurance and personal disability income coverage are ordinarily paid with after-tax dollars and are not deductible as a personal expense. Businesses may deduct premiums for genuine employee benefit coverage they provide, but not when the business is the beneficiary of the policy it is paying for. Medical expense premiums an individual pays may be deductible only as part of the medical expense rules, which are subject to limits set by federal tax law. Employer-paid group health premiums are generally a deductible business expense to the employer and are generally not taxable income to the employee, while employer-paid group life coverage is only excluded from the employee's income up to a limit fixed by federal law — coverage above that limit produces reportable income.

Growth inside the contract

Cash value in a permanent life policy and earnings inside a deferred annuity generally accumulate tax-deferred. Nothing is taxed while the gain stays inside the contract. That deferral, not deduction, is the tax advantage producers should be describing.

Proceeds coming out

• Death benefit. Life insurance proceeds paid by reason of the insured's death are generally received income-tax-free by the beneficiary. If the beneficiary leaves the money with the insurer or takes it in installments, the interest element is taxable even though the pure death benefit is not. Proceeds may still be part of the insured's taxable estate depending on ownership.
• Surrender, withdrawal, or policy loan. On a full surrender, the owner recovers cost basis (generally premiums paid) tax-free and is taxed on the gain above basis as ordinary income. Withdrawals and loans from a policy that has been overfunded under federal definitional limits lose that favorable ordering and are taxed gain-first, sometimes with an additional penalty tax if taken before the age federal law specifies.
• Annuity payments. Annuitized payments are split by an exclusion ratio: the portion representing return of the owner's investment in the contract is tax-free, and the balance is taxable as ordinary income. Non-annuitized withdrawals from a deferred annuity are generally taxed on gain first.
• Disability income benefits. The rule follows who paid: benefits are generally tax-free when the insured paid the premium with after-tax dollars, and generally taxable when the employer paid and took the deduction.

Why the exam cares — and why the regulator does

Tax treatment is a benefit of the policy, so how you describe it is regulated conduct. Misrepresenting the terms, benefits, advantages, or dividends of a policy is an unfair or deceptive act, and that includes overstating tax-free treatment or implying a deduction that does not exist.

Do not sell a tax result you cannot document, and do not give tax advice — refer the client to a tax professional.

Similarly, a producer may not use the existence of the guaranty association as an inducement in advertising or soliciting insurance; safety and tax claims are the two places where enthusiastic sales language most often crosses into a violation.