4.3 Taxation of Life Insurance & Annuities

Taxation of Life Insurance

Death Benefit

The single most-tested fact: a life insurance death benefit paid as a lump sum is received income-tax-free by the beneficiary under IRC Section 101(a). If the beneficiary instead chooses a settlement option that pays in installments, the principal portion is still tax-free, but the interest earned is taxable.

Cash Value, Withdrawals, and Loans

Cash value grows tax-deferred. The owner is not taxed on the inside buildup while the policy is in force.

• Withdrawals / surrender — taxed only to the extent the amount received exceeds the cost basis (total premiums paid). Gain above basis is ordinary income. This is FIFO (cost basis out first) for non-MEC life insurance.
• Policy loans — not taxable while the policy remains in force, because a loan is debt, not income. But if the policy lapses or is surrendered with a loan outstanding, any gain becomes taxable.

Modified Endowment Contracts (MECs) and the 7-Pay Test

Congress created the MEC rules (TAMRA 1988) to stop people from overfunding life insurance purely as a tax shelter. A policy becomes a Modified Endowment Contract if cumulative premiums paid during the first seven years exceed the 7-pay limit—roughly the amount needed to pay the policy up in seven level annual premiums.

Once a policy is a MEC, the tax treatment of living distributions changes dramatically:

• Withdrawals and loans are taxed LIFO (Last-In, First-Out)—gain (interest) comes out first and is taxable.
• A 10% penalty applies to the taxable amount if taken before age 59½.
• Once a MEC, always a MEC—the status is permanent and carries through a 1035 exchange.

The death benefit of a MEC is still income-tax-free; only the living benefits are penalized. The exam frequently contrasts MEC (LIFO, penalty) with ordinary life insurance (FIFO, loans tax-free).

1035 Exchanges and Dividends

1035 Exchanges

IRC Section 1035 lets an owner swap one policy for a like-kind contract without recognizing gain: life-to-life, life-to-annuity, annuity-to-annuity, and life or annuity to qualified long-term care are all permitted. The reverse—annuity-to-life is NOT allowed tax-free. Cost basis and MEC status carry over to the new contract.

Dividends

Dividends from a participating (mutual company) policy are treated as a return of overpaid premium, so they are not taxable. However, interest credited on dividends left to accumulate with the insurer IS taxable in the year earned. This distinction (dividend itself = tax-free; interest on it = taxable) is a classic exam trap.

Taxation of Annuities

Annuities grow tax-deferred during accumulation. Taxation occurs only when money comes out, and the method depends on whether the contract is annuitized or partially withdrawn.

The Exclusion Ratio (Annuitized Payments)

When an annuity is annuitized, each payment is split into a tax-free return of principal and a taxable interest portion using the exclusion ratio:

Exclusion Ratio = Investment in the Contract (cost basis) ÷ Expected Total Return

The resulting percentage of each payment is excluded (tax-free); the remainder is taxable ordinary income. Once the annuitant has recovered the entire cost basis (i.e., lives beyond life expectancy), all subsequent payments become fully taxable.

Withdrawals (Nonqualified Annuities)

Lump-sum or partial withdrawals before annuitization are taxed LIFO—interest (gain) comes out first and is fully taxable as ordinary income; only after all gain is withdrawn is the tax-free basis returned.

The 10% Penalty

Amounts withdrawn before age 59½ generally incur a 10% IRS penalty on the taxable portion, on top of ordinary income tax.

Qualified vs. Nonqualified

• Nonqualified annuity — funded with after-tax dollars; only the earnings are taxed on the way out (basis is already taxed). Exclusion ratio / LIFO rules apply.
• Qualified annuity — funded with pre-tax dollars inside an IRA or employer plan; the entire distribution is taxable because nothing was previously taxed, and RMD rules apply.

Annuity Death Benefits, Estate Tax, and Worked Examples

If the annuitant dies during accumulation, the beneficiary receives the death benefit (usually the greater of premiums paid or account value). Unlike a life insurance death benefit, the gain in an annuity is taxable income to the beneficiary—annuities do not enjoy the income-tax-free death benefit that life insurance does. This is a heavily tested contrast: life insurance death benefit = income-tax-free; annuity death benefit = gain is taxable.

For estate tax (a separate tax from income tax), life insurance proceeds are included in the insured's gross estate if the insured held any incidents of ownership at death, even though they pass income-tax-free to the beneficiary.

Worked Example — Exclusion Ratio

Suppose an annuitant invested $100,000 (cost basis) and the expected total return over life expectancy is $200,000. The exclusion ratio is $100,000 ÷ $200,000 = 50%. So 50% of each payment is tax-free (return of principal) and 50% is taxable interest. If the annuitant lives long enough to recover the full $100,000 basis, every later payment becomes 100% taxable.

Worked Example — LIFO Withdrawal

An owner has a nonqualified annuity worth $60,000, of which $40,000 is basis and $20,000 is gain. A $15,000 withdrawal is taxed under LIFO: all $15,000 is treated as gain and is fully taxable, plus a 10% penalty ($1,500) if the owner is under 59½. Only after the entire $20,000 gain is withdrawn would basis come out tax-free.

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