5.2 Taxation of Life Insurance & Annuities

The General Rule

Life insurance is tax-advantaged. Memorize three pillars:

1. Premiums on personal life insurance are not deductible (you pay with after-tax dollars).
2. Cash value grows tax-deferred — no tax while it accumulates inside the policy.
3. The death benefit paid in a lump sum is received income-tax-free by the beneficiary.

The Transfer-for-Value Exception

If a policy is sold/transferred for valuable consideration, the death benefit above the buyer's cost basis becomes taxable income. Exceptions that preserve tax-free status include transfers to the insured, a partner of the insured, a partnership in which the insured is a partner, or a corporation in which the insured is an officer or shareholder. A simple gift of a policy is not a transfer for value, so it does not trigger the rule.

Worked example: Investor X buys an in-force policy for $10,000 and pays $4,000 more in premiums (a $14,000 basis). When the insured dies, the $100,000 death benefit pays out. Because X is not a protected party, $86,000 ($100,000 − $14,000) is taxable income to X; only the $14,000 basis is tax-free.

Interest on Delayed or Installment Proceeds

When a beneficiary takes the death benefit under a settlement option instead of a lump sum, the principal stays income-tax-free, but any interest earned on the held proceeds is taxable. Under the interest-only option the entire payment is taxable interest; under installment options each payment is part tax-free principal and part taxable interest.

Living Benefits: Loans, Surrenders, Dividends

• Policy loans: borrowing against cash value is not taxable while the policy stays in force. If the policy lapses or is surrendered with a loan outstanding, gain becomes taxable.
• Surrender (cash-out): gain = cash surrender value minus cost basis (total premiums paid). Only the gain is taxable as ordinary income.
• Dividends: treated as a return of overpaid premium, so they are not taxable — but interest earned on dividends left to accumulate is taxable.

Modified Endowment Contract (MEC)

Congress created the MEC to stop using life insurance as a tax shelter. A policy is a MEC if it fails the 7-pay test — premiums paid in the first 7 years exceed the limit that would pay the policy up in 7 level annual payments. MEC consequences:

• Living distributions (loans, withdrawals) are taxed LIFO — gains come out first and are taxable.
• A 10% penalty applies to the taxable portion taken before age 59 1/2.
• The death benefit remains income-tax-free. Once a MEC, always a MEC.

7-pay illustration: suppose a policy could be fully paid up in seven annual payments of $5,000 (a $35,000 cumulative limit). If the owner instead dumps $50,000 in year one, premiums exceed the limit and the contract is a MEC for life. A $9,000 loan at age 50 is then taxed gain-first (LIFO) plus the 10% early penalty — exactly the abuse the rule targets.

Section 1035 Exchanges

A 1035 exchange lets an owner swap one contract for another without recognizing gain, preserving the original cost basis. Permitted directions:

The rule is one-directional: you can move from life into an annuity but never from an annuity into life insurance.

Annuity Taxation

During the accumulation phase, an annuity grows tax-deferred. Withdrawals from a deferred annuity are taxed LIFO (interest/gain first), with the same 10% penalty before 59 1/2.

When annuitized, the exclusion ratio determines the tax-free portion of each income payment:

Exclusion ratio = investment in the contract (basis) ÷ expected total return.

The resulting percentage of each payment is a tax-free return of basis; the remainder is taxable interest. Once the entire basis has been recovered, all further payments are fully taxable.

Worked example: an owner annuitizes with a $100,000 basis and an expected total return of $150,000. The exclusion ratio is $100,000 ÷ $150,000 = 66.67%. On each $1,000 monthly payment, $666.70 is tax-free return of basis and $333.30 is taxable interest — until the full $100,000 basis is recovered, after which the entire payment is taxable.

Estate Tax & Incidents of Ownership

The income-tax-free rule does not exempt proceeds from estate tax. If the insured held any incident of ownership at death — the right to change the beneficiary, take a loan, surrender, or assign the policy — the full death benefit is included in the insured's gross estate. Transferring ownership (e.g., to an irrevocable life insurance trust) removes proceeds from the estate, subject to a 3-year look-back.

Qualified vs. Nonqualified Plans (Overview)

Qualified plans use pre-tax contributions, grow tax-deferred, and distributions are fully taxable as ordinary income; required minimum distributions (RMDs) generally begin at age 73. Because there is zero cost basis, every dollar out is taxed. Examples: Traditional IRA, 401(k), 403(b)/TSA, SEP, and Section 412(e)(3) fully-insured defined-benefit plans funded entirely with life insurance and annuity contracts.

Nonqualified plans/annuities use after-tax money, so only the earnings are taxable on distribution; the basis comes out tax-free (or via the exclusion ratio once annuitized). No RMDs apply. A Roth IRA is funded with after-tax dollars and offers tax-free qualified withdrawals after age 59 1/2 and a 5-year holding period.

Early-Withdrawal Penalty

The 10% penalty before age 59 1/2 applies to taxable amounts from annuities, MECs, and qualified plans alike. Exceptions include death, disability, and (for annuities annuitized) a properly structured income stream. Pair this with the LIFO rule: gains come out first, so early withdrawals are usually fully taxable and penalized.