10.2 Taxation of Life Insurance (Death Benefit, MEC, Transfer-for-Value)

Taxation of Life Insurance

Life insurance enjoys favorable federal tax treatment, which is why exams test the exceptions to those rules. The headline rule: a death benefit paid in a lump sum to a named beneficiary is received income-tax-free. Cash value grows tax-deferred inside the policy. This section covers death-benefit taxation, the Modified Endowment Contract (MEC) rules and the seven-pay test, and the transfer-for-value rule that can strip the tax exemption.

Death-benefit taxation

A lump-sum death benefit is excluded from the beneficiary's gross income. However, if the beneficiary leaves the proceeds with the insurer under a settlement option, the interest portion earned on those proceeds is taxable as ordinary income; the principal remains tax-free.

While the death benefit avoids income tax, it may be included in the deceased's estate for estate-tax purposes if the insured held any incident of ownership (the right to change beneficiaries, borrow, or surrender). Ownership by an irrevocable life insurance trust can keep proceeds out of the taxable estate.

Living-benefit and cash-value taxation

• Cash value growth is tax-deferred while inside the contract.
• Policy loans are generally not taxable while the policy stays in force (the loan is debt, not income).
• Surrender or lapse: gain above cost basis (premiums paid minus dividends received) is taxable as ordinary income.
• Dividends from participating policies are a return of premium and are not taxable until cumulative dividends exceed total premiums paid; interest earned on dividends left on deposit is taxable.

Modified Endowment Contract (MEC) and the seven-pay test

Congress created the MEC rules to stop investors from overfunding life policies purely as tax shelters. A policy becomes a MEC if cumulative premiums paid during the first seven years exceed the seven-pay limit — the level annual premium that would fully pay up the policy in seven years. This is the seven-pay test.

A MEC is still life insurance: the death benefit stays income-tax-free. What changes is the taxation of living distributions during the insured's life.

How MEC distributions are taxed

Once a policy is a MEC, lifetime distributions — loans, withdrawals, and partial surrenders — are taxed Last-In, First-Out (LIFO): earnings come out first and are taxable as ordinary income. A 10% penalty also applies to the taxable amount if the owner is under age 59 1/2 (subject to exceptions for death, disability, or substantially equal payments).

Key trap: once a MEC, always a MEC. The taint cannot be reversed, and it passes to any policy received in exchange. The seven-pay test also restarts if the death benefit is materially reduced.

Seven-pay test illustration

Assume a whole life policy has a calculated seven-pay limit of $5,000 per year, so total allowed premiums over seven years are $35,000.

An $8,000 first-year premium against a $5,000 limit triggers MEC status immediately. Paying at or below the limit keeps the policy out of MEC territory.

Transfer-for-value rule

Normally death proceeds are income-tax-free. The transfer-for-value rule breaks that exemption: if a life policy is transferred (sold) for valuable consideration, the death benefit becomes taxable to the extent it exceeds the buyer's consideration plus subsequent premiums paid.

Transfer-for-value exceptions

Exceptions that preserve the tax-free death benefit include transfer:

• to the insured
• to a partner of the insured
• to a partnership in which the insured is a partner
• to a corporation in which the insured is an officer or shareholder
• a transfer with a carryover basis (such as a gift)

Note there is no exception for a transfer to a fellow shareholder individually — only to the corporation itself. Memorize this list; it is heavily tested.

Premium deductibility and business uses

Generally, premiums for personal life insurance are NOT tax-deductible — they are a personal expense. A business that pays premiums on a key-person or buy-sell policy also cannot deduct the premiums when the business is the beneficiary, but the death benefit it later collects is received income-tax-free.

Under a Section 162 executive bonus plan, the employer pays the premium and deducts it as compensation; the bonus is then taxable income to the employee, who owns the policy. Group term life premiums up to $50,000 of coverage are tax-free to the employee.

Scenario: accelerated and viatical benefits

Accelerated (living) benefits paid to a terminally ill insured (life expectancy generally 24 months or less) are received income-tax-free, treated like an early death benefit. The same applies to a viatical settlement paid to a chronically or terminally ill insured.

Trap: a sale to an unrelated investor who is NOT chronically/terminally ill is a life settlement subject to ordinary tax rules, and the death benefit in the investor's hands is governed by the transfer-for-value rule — not the tax-free exception. The viatical insured must obtain a physician's certification of qualifying illness for the proceeds to qualify for income-tax exclusion under the rules.