Tax treatment of life insurance premiums, proceeds, and MECs

Three tax questions every life policy raises

Federal income tax treats a life insurance policy at three points: when premiums go in, while cash value grows and is taken out during the insured's life, and when the death benefit is paid. A policy that is funded too quickly can also become a modified endowment contract (MEC), which changes the rules for living withdrawals and loans but not for the death benefit.

Premiums

For an individual, premiums on personal life insurance are not deductible. They are a personal expense, like paying for your own groceries. The trade-off is that the death benefit they buy is generally received income-tax-free.

Business situations follow the same logic:

• When a business pays premiums on a policy that names the business as beneficiary (key person or buy-sell coverage), the premiums are not deductible, and the death benefit comes back to the business generally income-tax-free.
• An employer can deduct premiums for group term life as a business expense. The cost of the first $50,000 of coverage is not taxable income to the employee; the cost of coverage above $50,000 is taxable to the employee.

Cash value: tax-deferred growth

Interest and investment growth credited to a permanent policy's cash value is not taxed as it accrues. This "inside buildup" is tax-deferred only if the contract qualifies as life insurance under federal law, which means passing either the cash value accumulation test or the guideline premium and cash value corridor test. If a contract fails that definition, the income on the contract is taxed to the policyholder as ordinary income every year.

The owner's cost basis is the total premiums paid, minus any dividends and other amounts already received tax-free.

• Dividends on a participating policy are treated as a return of excess premium, so they are not taxable (until total dividends exceed total premiums paid). Interest earned on dividends left to accumulate is taxable in the year it is credited.
• Surrender: if the policy is surrendered for its cash value, only the amount above the cost basis is taxable, as ordinary income.
• Withdrawals from a policy that is not a MEC are taxed first-in, first-out (FIFO): basis comes out first, tax-free, and only amounts above basis are taxable.
• Policy loans from a policy that is not a MEC are not taxable while the policy stays in force, because a loan is not income.
• A Section 1035 exchange lets an owner exchange one life policy for another life policy (or for an annuity) without recognizing gain.

Death benefit

Life insurance proceeds paid to a beneficiary because of the insured's death are generally excluded from the beneficiary's gross income when paid as a lump sum. Two important limits:

• If proceeds are left with the insurer under a settlement option, the principal stays tax-free but the interest the insurer pays on it is taxable.
• Transfer for value: if a policy is sold to a new owner for value, the death benefit is generally tax-free only up to what the buyer paid plus later premiums, with exceptions such as a transfer to the insured, a partner of the insured, or a partnership or corporation in which the insured is a partner or shareholder.

Accelerated death benefits paid to a terminally ill or chronically ill insured are treated as paid by reason of death, and so receive the same exclusion. So does money a terminally or chronically ill insured receives for selling the policy to a licensed viatical settlement provider.

Income tax is not estate tax: proceeds are included in the insured's federal gross estate if the insured held any incident of ownership in the policy at death, or if the proceeds are payable to the estate.

Modified endowment contracts

A MEC is a life insurance contract entered into on or after June 21, 1988 that fails the 7-pay test. The test asks whether the total paid into the contract at any time in its first 7 contract years exceeds the sum of the net level premiums that would have paid the policy up in 7 level annual premiums. Put in too much, too fast, and the contract becomes a MEC.

• A contract received in exchange for a MEC is also a MEC: once a MEC, always a MEC.
• A material change (such as an increase in benefits) is treated as a new contract entered into on the date of the change, and the 7-pay test starts again.
• If benefits are reduced within the first 7 years, the test is reapplied as if the policy had been issued at the lower benefit, which can turn it into a MEC retroactively.

A MEC is still life insurance. Its cash value still grows tax-deferred and its death benefit is still income-tax-free. What changes is the treatment of living distributions:

• Withdrawals and policy loans are taxed last-in, first-out (LIFO): gain comes out first, as ordinary income, before any tax-free return of basis.
• A 10% additional tax applies to the taxable part of a distribution unless the owner is at least 59½, is disabled, or takes a series of substantially equal periodic payments over life or life expectancy.

Remember: premiums are not deductible, inside buildup is tax-deferred, the death benefit is income-tax-free, and a MEC changes only how the money comes out while the insured is alive.