Income Taxation of Life Insurance
Benefits
What is life insurance?
Webster's dictionary defines life insurance
as "insurance providing for payment of a stipulated sum to a designated
beneficiary upon death of the insured." However, the tax code has its own
definition of life insurance. If your life insurance policy qualifies under the
tax code's definition, you and the policy's beneficiaries may enjoy many income
tax advantages. This discussion focuses on the income tax implications
surrounding life insurance benefits. For a discussion in general about the
income tax implications of life insurance, see Income Taxation of Life
Insurance.
What are life insurance benefits?
Life
insurance benefits fall into two major categories:
Living benefits--Living benefits refer to
amounts received before the insured's death (e.g., dividends, cash withdrawals,
policy loans).
Death benefits--Death benefits refer to
proceeds under the policy and received by the beneficiary(ies) after the insured's
death and because of the insured's death. Qualified accelerated death benefits
refer to benefits received by you (the insured) before your death and because
you are terminally or chronically ill (see below for further information).
How are living benefits treated
for income tax purposes?
Principal
Life insurance principal means the same as
basis does for other types of assets. It is the total amount you have paid in
premiums minus any non-taxable amounts that you have received (this is referred
to as the net premium cost). Living proceeds you receive that are classified as
principal are not subject to income tax.
Policy loans
You may borrow against your life insurance
policy. Loan proceeds are generally not treated as taxable income. Loans from a
modified endowment contract (MEC) are taxed differently. Generally, loans from
an MEC are taxable as income to the extend the cash value of the policy exceeds
your investment (premiums paid) in the contract.
Caution: Generally the interest you pay on a policy loan is not
deductible, unless an exception applies.
Caution: An outstanding loan is generally treated as an amount received
and may result in taxable income if the policy is surrendered or sold.
Distributions
If you receive distributions (e.g., dividends,
withdrawals, surrender) from the policy, they are treated as non-taxable
principal until the full amount of the principal has been recovered, and any
further distributions of living benefits are treated as taxable income at
ordinary rates. This is called the cost recovery rule.
There are
certain exceptions to this general rule:
Distributions from universal life
policies--Disbursements received in the first 15 years (from the policy issue
date) as a result of a decrease in benefits may be taxed as income first (this
is called the income-out-first rule).
Distributions from modified endowment
policies--Distributions from a modified endowment contract are subject to the
income-out-first rule.
How are death benefits treated
for income tax purposes?
Death
benefits in general
The general rule is that proceeds from a life
insurance policy received by your beneficiaries when you die are excluded from
income.
Interest
earned on death benefits
A beneficiary, if given such an option in the
policy, may choose to receive death benefits in installments. In this case, the
beneficiary receives annual payments that are part principal and part interest.
The part that is classified as interest is treated as ordinary income. The part
that is classified as principal is not taxable under the general rule.
Also, a beneficiary may choose to leave the
death benefits entirely with the insurance company, if given such an option in
the policy. This is known as the interest-only option and is not commonly used
today. Here, interest is earned on the benefits. The interest may be
distributed to the beneficiary or it may stay with the insurance company. The
interest is taxable to the beneficiary in the year in which it is earned,
whether or not the beneficiary actually receives it (under the doctrine of
constructive receipt). The interest is taxable income to the beneficiary at
ordinary rates. When the beneficiary does receive the principal, it is not
taxed under the general rule. A surviving spouse who chooses to receive
interest only may not take the $1,000 interest exclusion.
Tip: This does not apply to government life insurance policies where
interest earned is tax free.
Death
benefits received under a "sold" policy
Under the transfer-for-value rule, death
benefits received under a policy that has been exchanged or transferred--that
is, sold--for a consideration such as money or something of value are subject
to income tax at ordinary rates to the extent of the dollar value of the
consideration and any premiums subsequently paid by the transferee.
Example(s): Fred buys a $100,000 life insurance policy. For five years, Fred
pays the premiums ($500 each year or $2,500). Fred sells the policy to Barney
for $2,500, and Barney pays the annual premiums for six more years ($3,000).
Fred dies. Barney receives the $100,000 death benefit. Barney's income, subject
to income tax, is $94,500 ($100,000 - $2,500 - $3,000).
There are
some exceptions to the transfer-for-value rule:
Transfers made to the insured
Transfers made to a partner of the insured
Transfers made to a partnership in which the
insured is a partner
Transfers made to a corporation in which the
insured is a stockholder or officer
Transfers in which the transferee has a basis
in the policy determined by reference to the transferor's basis in the policy
Transfers made between spouses after July 18,
1984 (or December 31, 1983, if elected)
Certain transfers between former spouses
incident to a divorce
Death
benefits received by creditors
You may name a creditor as a beneficiary to
use life insurance to pay off a debt. In this case, the IRS is apt to argue
that the death benefits should be subject to income tax (taxable to the
creditor). The IRS's position is that the death benefits are received because
of indebtedness and not because of the insured's death.
Tip: The counter-argument in this case is that the income is a
recovery of basis unless it has been written off as a bad debt.
Death
benefits considered compensation or dividends
In some circumstances, the payment of death
benefits may be classified as compensation; for example, when an employer-owned
policy distributes benefits as pay to an employee. In this case, the death
benefits may be either: (1) treated as compensation and so as taxable income to
the employee decedent at ordinary rates and deductible by the employer, or (2)
in the case of distribution of the benefits to a shareholder, treated as a
dividend and so taxable to the employee decedent to the extent of earnings, but
not deductible by the employer.
Death
benefits from a policy owned by a qualified retirement plan
When death benefits are paid from a policy
owned by a qualified retirement plan, a portion of the benefits equal to the
cash surrender value of the policy immediately before the insured's death is
treated as a distribution from the plan taxable at ordinary rates.
How are qualified accelerated
death benefits treated for income tax purposes?
In general, if you receive death benefits
(i.e., qualified accelerated death benefit) early because you are terminally or
chronically ill, they are treated as if they were received because of your
death and are not subject to income tax. The amount of the exclusion may be
limited if you are chronically ill, but there is no limit on the exclusion if
you are terminally ill.
Caution: Accelerated death benefits received before 1996 don't receive
this special tax treatment.
Technical
Note: Terminal illness means that you are expected
to die within 24 months.
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IMPORTANT DISCLOSURES
The
information presented here is not specific to any individual's personal
circumstances.
To the extent
that this material concerns tax matters, it is not intended or written to be
used, and cannot be used, by a taxpayer for the purpose of avoiding penalties
that may be imposed by law. Each taxpayer should seek independent advice from a
tax professional based on his or her individual circumstances.
These
materials are provided for general information and educational purposes based
upon publicly available information from sources believed to be reliable—we
cannot assure the accuracy or completeness of these materials. The information
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