Life Insurance Fundamentals

Life insurance is a cornerstone of financial planning, providing essential protection against the economic consequences of premature death. For CFP candidates, understanding life insurance goes beyond policy types to include tax treatment, policy features, and the regulatory framework governing these contracts. This section covers why life insurance matters, how death benefits are taxed, policy loan provisions, accelerated death benefits, and the critical Modified Endowment Contract (MEC) rules.

Why Life Insurance Matters

The fundamental purpose of life insurance is income replacement. When the primary wage earner dies, the surviving family members lose not just a loved one but also the income that supported their lifestyle, funded their goals, and provided their financial security.

Key Uses of Life Insurance

The Income Replacement Calculation

A simple income replacement calculation considers:

• Annual income to be replaced
• Number of years income is needed
• Existing assets and insurance already in place
• Social Security survivor benefits available

Example: A 40-year-old earning $100,000 annually with 25 years until retirement might need $1.5-2.5 million in coverage, depending on family expenses, inflation assumptions, and investment returns.

Death Benefit Tax Treatment

One of the most important tax advantages of life insurance is the income tax treatment of death benefits. Under IRC Section 101(a), death proceeds paid to a beneficiary are generally excluded from gross income.

General Rule: Income Tax-Free Death Benefits

When a policy owner dies and the death benefit is paid to the named beneficiary, the entire amount is received income tax-free. This applies regardless of:

• The size of the death benefit
• Whether the policy is term or permanent
• The relationship between the insured and beneficiary
• How long the policy has been in force

Example: John purchases a $1 million life insurance policy and pays $50,000 in total premiums over his lifetime. When he dies, his beneficiary receives the full $1 million income tax-free. The $950,000 gain is not taxable income.

Exceptions to Tax-Free Treatment

The Transfer for Value Rule

If a life insurance policy is transferred for valuable consideration, the death benefit loses its income tax-free status. The new owner will pay income tax on the death benefit minus their basis (purchase price plus subsequent premiums).

Exceptions to Transfer for Value Rule (death benefit remains tax-free):

1. Transfer to the insured
2. Transfer to a partner of the insured
3. Transfer to a partnership in which the insured is a partner
4. Transfer to a corporation in which the insured is a shareholder or officer
5. Transfer with a carryover basis (gift)

Exam Tip: Transfer for Value

The CFP exam frequently tests the transfer for value rule. Remember that selling a policy to a third party (like a stranger or unrelated business) triggers the rule, but transfers to related parties generally do not.

Policy Loans

A significant advantage of permanent life insurance (whole life, universal life, variable life) is the ability to borrow against the policy's cash value. Understanding the tax treatment of policy loans is critical for CFP candidates.

How Policy Loans Work

• The insurance company lends money using the policy's cash value as collateral
• The policy owner is not required to make any payments on the loan
• Interest accrues on the outstanding loan balance
• The death benefit is reduced by any outstanding loan balance
• If the loan exceeds the cash value, the policy lapses

Tax Treatment of Policy Loans (Non-MEC Policies)

For policies that are not Modified Endowment Contracts:

Important: If a policy lapses or is surrendered with an outstanding loan, the tax consequence can be severe. The policy owner may owe income tax even though they received no additional cash.

Example: Maria has a policy with $100,000 cash value and $40,000 basis. She borrowed $90,000 over the years. If the policy lapses:

• Taxable gain = $100,000 (cash value) - $40,000 (basis) = $60,000
• Maria owes income tax on $60,000 even though she has no cash to pay it

Exam Tip: Phantom Income from Policy Loans

Watch for CFP exam questions involving policy lapses with large outstanding loans. The "phantom income" scenario where someone owes taxes but has no cash is a common exam topic.

Accelerated Death Benefits

Accelerated death benefits (ADB) allow terminally or chronically ill policyholders to access a portion of their death benefit while still alive. Under HIPAA (Health Insurance Portability and Accountability Act of 1996), these benefits receive favorable tax treatment.

Tax-Free Treatment Requirements

Accelerated death benefits are income tax-free when:

Activities of Daily Living (ADLs):

1. Eating
2. Toileting
3. Transferring (bed to chair)
4. Bathing
5. Dressing
6. Continence

Chronic Illness Limits

For chronically ill individuals, accelerated death benefits are tax-free up to the greater of:

• Actual long-term care costs, OR
• The per diem limit ($420/day in 2024, indexed annually)

Benefits exceeding these limits may be taxable.

Exam Tip: Terminal vs. Chronic Illness

The CFP exam distinguishes between terminal illness (24-month life expectancy, fully tax-free) and chronic illness (ADL-based, subject to per diem limits). Know both definitions.

Modified Endowment Contracts (MECs)

A Modified Endowment Contract (MEC) is a life insurance policy that has been "overfunded" based on IRS guidelines. MECs lose some of the favorable tax treatment that applies to regular life insurance policies.

The 7-Pay Test

A policy becomes a MEC if cumulative premiums paid during the first seven years exceed the net level premium needed to pay up the policy in seven equal annual installments.

Key Points about the 7-Pay Test:

• Applies to policies purchased on or after June 21, 1988
• Calculated at policy issue based on death benefit and insured's age
• A new 7-pay period begins after any "material change" (reduced death benefit, certain riders added)
• MEC status is permanent and cannot be reversed

Why MEC Status Matters

LIFO vs. FIFO Taxation

FIFO (First-In, First-Out) - Non-MEC policies:

• Withdrawals are treated as a return of basis first
• Only taxable after entire basis is recovered
• Policy loans are not treated as distributions

LIFO (Last-In, First-Out) - MEC policies:

• Withdrawals come from gains first
• Immediately taxable if any gain exists
• Policy loans treated as taxable distributions
• 10% penalty if taken before age 59 1/2

Example: A policy has $100,000 cash value and $60,000 basis (gain of $40,000).

Withdrawal of $20,000:

• Non-MEC: $20,000 tax-free (return of basis)
• MEC: $20,000 taxable as ordinary income (gains out first), plus 10% penalty if under age 59 1/2

When MEC Status Might Be Acceptable

Some clients intentionally create MECs when:

• They primarily want the income tax-free death benefit
• They do not plan to access cash value during their lifetime
• They want to maximize cash value accumulation
• Premium financing or single-premium situations

Correcting a MEC

If a policy inadvertently becomes a MEC:

• The insurance company typically has 60 days to return excess premiums
• If excess is returned within the grace period, MEC status may be avoided
• Once MEC status is established, it cannot be reversed

Exam Tip: 7-Pay Test Calculations

The CFP exam may ask you to identify when a policy becomes a MEC. Focus on the concept that any time cumulative premiums exceed the calculated 7-pay limit, MEC status is triggered. Material changes restart the 7-pay period.

Life Insurance Taxation Summary

Section 1035 Exchanges

A 1035 exchange allows policy owners to exchange one life insurance policy for another, or for an annuity, without triggering current income tax on any gain.

Permitted 1035 Exchanges

Important: The basis from the old policy carries over to the new policy. MEC status also carries over so you cannot exchange a MEC for a non-MEC policy to eliminate the MEC classification.

Exam Tip: 1035 Exchange Direction

Remember the one-way rule: you can exchange life insurance for an annuity (moving down the "hierarchy"), but you cannot exchange an annuity for life insurance without triggering tax.