Tax treatment of life insurance premiums, proceeds…

Three questions the tax code asks

Life insurance gets unusually kind treatment under federal income tax law. To see where the kindness stops, ask three questions: are the premiums deductible, are the proceeds taxable, and what happens to the cash value while the owner is alive?

Premiums

For an individual, life insurance premiums are a personal expense and are not deductible. The same is true when a business pays premiums on a policy that benefits the business itself, such as key person insurance: no deduction, but the proceeds arrive tax free. Premiums a business pays as compensation for an employee's benefit are generally deductible by the business — and then may be taxable to the employee. One common exception: an employer may provide up to $50,000 of group term life coverage without the employee being taxed on its cost.

Death proceeds

The general rule is simple: a death benefit paid to a beneficiary in a lump sum is not income to the beneficiary. This rule lives in 26 U.S.C. § 101, which is why the section is titled "Certain death benefits." Two points narrow it:

Interest is taxable. If the beneficiary leaves the proceeds with the insurer under a

settlement option, the principal stays tax free, but the interest the insurer adds is taxable income.

Transfer for value. If a policy is sold to a new owner for money, the death benefit

can lose most of its exclusion: the buyer is taxed on the proceeds above what the buyer paid, plus later premiums.

Living benefits paid early

Money received under a life insurance contract on an insured who is terminally ill or chronically ill is treated as if it were paid by reason of the insured's death — so it gets the same exclusion (26 U.S.C. § 101(g)(1)). The same treatment applies when that insured sells or assigns the death benefit to a viatical settlement provider: the sale price is treated as a death benefit (26 U.S.C. § 101(g)(2)(A)).

Cash value while the insured is alive

Growth is tax-deferred. The owner is not taxed on cash value increases year by year.

That shelter depends on the contract meeting the federal definition of life insurance; a contract that fails it has its yearly income taxed as ordinary income to the policyholder (26 U.S.C. § 7702(g)(1)(A)).

Cost basis is generally the total premiums paid, less any dividends taken in cash.
Surrender: only the gain — the cash value received above the cost basis — is taxed,

as ordinary income.

Dividends are treated as a return of premium, so they are not taxable until they

exceed the basis. Interest earned on dividends left with the insurer is taxable.

Withdrawals from an ordinary policy come out basis first (first in, first out), so

they are tax free until the basis is used up.

Policy loans are not taxable while the policy stays in force. A policy that lapses or

is surrendered with a loan outstanding can create taxable gain.

Modified endowment contracts

Congress closed a loophole: people were stuffing large premiums into life policies to use them as tax-sheltered savings accounts. The answer is the modified endowment contract (MEC).

A MEC is a contract that meets the definition of life insurance but was entered into on or after June 21, 1988 and fails the 7-pay test — or was received in exchange for a MEC (26 U.S.C. § 7702A(a)). The 7-pay test is failed if, at any time in the first 7 contract years, the premiums paid exceed what would have been paid by then if the policy were fully paid up after 7 level annual premiums (26 U.S.C. § 7702A(b)).

A line chart of the seven-pay test. The horizontal axis shows contract years one through seven; the vertical axis shows total premiums paid. A dashed black line rises steadily from year one to year seven: this is the seven-pay limit, the total that would have been paid by each year if the policy were paid up after seven level annual premiums. The area under the line is shaded green, the area above it pink. A green line, labeled at or below, not a M E C, represents a normally funded policy: it climbs gradually and stays just under the limit every year. A red line represents an overfunded policy: it starts just under the limit, jumps above it in year two, and stays above it. A red dot marks the crossing, labeled M E C from here on. A footer notes that the test runs for the first seven contract years, and again after a material change. — The 7-pay test: premiums that exceed the seven-pay limit in the first 7 contract years make the policy a MEC.

Reducing benefits in the first 7 years retests the policy as if it had been issued at

the lower benefit, which can make it fail. A reduction caused by unpaid premiums is ignored if benefits are reinstated within 90 days (26 U.S.C. § 7702A(c)(2)).

A material change to benefits or terms makes the policy a new contract for the test,

starting a new 7-year period (26 U.S.C. § 7702A(c)(3)).

Once a MEC, always a MEC, and a policy exchanged for a MEC is a MEC too.

How a MEC is taxed

The death benefit is still income tax free. A MEC is still life insurance.
Loans and withdrawals come out gain first (last in, first out), so they are taxable

until all the gain has been taxed.

The taxable portion also carries a 10% additional tax, unless the owner is **59½ or

older, is disabled, or takes substantially equal periodic payments** for life (26 U.S.C. § 72(v)).

Rule of thumb: an ordinary policy lets you take your own money out first; a MEC makes you take the taxable gain out first.

Tax treatment of life insurance premiums, proceeds, and MECs