Tax treatment of life insurance and annuities, including modified endowment contracts

Start with basis and earnings

These are federal income-tax concepts for California insurance candidates. Basis, also called investment in the contract, generally represents after-tax money not yet recovered. Earnings are the gain above that investment. Personal life insurance premiums are generally not deductible. Cash-value growth inside a qualifying life policy is generally tax deferred. Death proceeds paid to a beneficiary are generally income-tax free, while interest paid on retained proceeds is taxable. Income-tax exclusion does not establish estate-tax exclusion. Exceptions and contract-specific rules can change the result; this lesson uses ordinary individual contracts unless stated otherwise.

Life insurance during life

For a non-modified-endowment life policy, ordinary partial withdrawals generally recover basis first. Policy loans generally produce no current income while the policy remains in force, but a later lapse or surrender with debt can produce taxable gain. On a full surrender, proceeds above adjusted basis are ordinary income. Policy dividends generally return premium and reduce basis; interest earned on retained dividends is taxable.

Modified endowment contracts

A modified endowment contract, or MEC, still meets the federal definition of life insurance but has different distribution taxation. Under section 7702A, a modern policy fails the seven-pay test when cumulative payments exceed the cumulative permitted seven-pay premiums during the first seven contract years. This is a funding-limit test, not a requirement to pay premiums for seven years. Certain material changes trigger a new test; early benefit reductions can require recalculation. A policy received in exchange for a MEC retains MEC status.

MEC withdrawals and loans generally distribute earnings first, then basis. The taxable portion can also incur a ten-percent additional federal tax before age fifty-nine and a half, unless an exception applies, such as qualifying disability or qualifying substantially equal periodic payments. Reaching that age removes the age-related additional tax, not ordinary income tax. MEC status does not itself eliminate the usual death-benefit income-tax exclusion. Failing section 7702's life-insurance qualification is a separate issue from failing the seven-pay test.

Annuities

An individually owned nonqualified annuity is generally funded with after-tax dollars and grows tax deferred. Before annuitization, withdrawals generally take taxable earnings first. After annuitization, the exclusion ratio allocates payments between tax-free basis recovery and taxable income: investment divided by expected return. An investment of sixty thousand dollars and expected return of one hundred thousand dollars gives a sixty-percent exclusion ratio. Of a one-thousand-dollar payment, six hundred dollars is excluded and four hundred dollars is taxable, until basis is exhausted. Later payments are fully taxable.

Taxable premature annuity distributions can incur a ten-percent additional federal tax, subject to exceptions. A qualified annuity funded entirely with pretax money generally has fully taxable distributions; do not invent after-tax basis.