The Internal Revenue Service administers and regulates taxation on life insurance, annuities, endowments and other retirement funds, including individual retirement accounts. Having a basic understanding of the various taxes involved with these contracts is important in understanding their structure and how they qualify (or don’t qualify) for favorable tax treatment by the IRS.
Knowing how taxation is levied on each type of contract can be understood through how the money within these contracts is exchanged. When a ‘taxable event’ occurs, the IRS levies an ordinary income tax on the money being exchanged as these events result in actual income being earned on behalf of a policyowner or beneficiary (based on the death benefit payout) and distributed as income payments.
Policy Funding and Accumulation
Neither life insurance nor annuity premiums are tax deductible for any type of life insurance policy or annuity, except for a percentage of an individual’s contribution in an individual retirement account or individual retirement annuity.
Interest earned on a life insurance policy is part of the policy’s ‘cash value accumulation,’ and is considered deferred income, taxed only when policy funds are distributed from the investment. Allowing interest to grow at a compounded rate without taxation over the policyowner’s lifetime provides a much greater return on the invested funds.
Similarly, while in the accumulation period, an annuity accumulates earnings on a tax-deferred basis since funds are reinvested into the annuity and not distributed to the policyowner. Again, the annuity accumulates cash value through principal and earned interest and is considered deferred income, tax-deferred until the fund annuitizes and begins distributing income to the annuitant.
Cash Value Increases
Compared to most investments which are taxed as ordinary income on an annual basis, life insurance provides individuals a means of tax-deferred growth. In addition, most investment distributions are taxed as ordinary income to the beneficiary of the contract in the event of the contract owner’s death. Life insurance, in comparison, provides the policyowner’s beneficiary with a tax-free distribution of the death benefit.
Although most individuals purchase life insurance to provide future financial protection for their survivors’ well-being, it provides an attractive return on investment, in addition to receiving favorable tax treatment, and can be misused as a ‘tax shelter’ for funds that should otherwise be taxed as earned income.
To curb the increase in life insurance as an investment vehicle and tax shelter, Congress has created a set of tests for a life insurance policy to qualify for a tax advantage and avoid the tax-shelter scenario.
CVAT vs. GPT
Cash Value Accumulation Test (CVAT)Using the cash value accumulation test, the policy’s cash value must not exceed the amount that would be required as a lump-sum premium to fully pay off the policy based on the policy’s face amount, based on the age of the insured.
Guideline Premium Test (GPT)
Using the guideline premium test, the policy’s premiums cannot exceed the amount that would be required to fully pay off the policy based on the policy’s face amount, as well as the age of the insured.
The primary difference between the cash value accumulation test (CVAT) and the guideline premium test (GPT) is that the CVAT pertains to cash value limits relative to the policy’s death benefit, while the GPT pertains on premium limits relative to the policy’s death benefit. If the cash value or premiums paid exceed the amount allowable under either test, the policy is no longer considered life insurance and is taxed the same as an investment (as ordinary income).
Again, these tests are guidelines to ensure that a policy continues to qualify as life insurance and receive favorable tax treatment. If a policy does not pass one of the two tests required by the IRS, it is not considered to be true life insurance and is taxed the same as a non-qualified investment plan; although, most insurers provide notice to their policyowners before such an event occurs to avoid this taxation issue.
While most individuals never contribute amounts high enough to require the use of these tests, the IRS uses these tests to prohibit investors from potentially exploiting the tax advantages associated with true life insurance.
Dividend Returns
Dividends paid out to participating policyowners in a mutual life insurance contract are considered to be a reimbursement of premium paid to the insurer and are paid back on a tax-free basis; however, any interest paid to policyowners in addition to the premium reimbursement is considered to be income and is taxable.
Policy Loans
Another tax advantage associated with life insurance is the ability to withdraw funds in the form of a policy loan without being taxed. Since a loan must be paid back, including accrued interest, it is not taxed; however, if the policyowner surrenders his or her policy, an income tax is levied against any gain in the policy’s loan value amount.
If the policyowner dies before repayment of the loan, the policy’s death benefit is reduced by the amount of outstanding loan and accrued interest, with the remainder lump sum being tax-free for the beneficiary (unless a recurring payment option is selected).
Policy Settlement Options
Policy surrendersIn the event that a policyowner surrenders his or her policy to the insurer, proceeds equaling the premium paid into the policy are tax-free, while policy surrender proceeds that exceed the cost of the policy are taxable by the IRS. Any pre-tax premium payments and interest earned before forfeiting the plan are taxable as earned income.
Accelerated benefits and Viatical settlements
Under current laws, as long as a policyowner is considered to be chronically or terminally ill, both accelerated benefits and policy proceeds from a viatical settlement are paid out on a tax-free basis.
Death Benefit Proceeds
Death benefit proceeds are paid income tax-free to a policy’s beneficiary if it is paid out as a lump-sum amount. If the beneficiary elects to receive continual income payments, or ‘installments,’ from the death benefit, instead of the lump-sum amount, only the interest that accrues from the principal is taxed as ordinary income to the beneficiary, but not the actual death benefit amount.
Group Life Insurance
Group life insurance includes certain tax advantages for businesses as a means of promoting group insurance for employees. Premiums paid by the employer are tax deductible for the employer as a form of business expense.
In a group life policy, employee premium contributions are not tax deductible; however, employees do not need to report their employer-paid premiums as income as long as their policy coverage is $50,000 or less. This is due to the fact that policy premium payments by the employer are not considered income to the employee up to the first $50,000. If, however, the policy coverage exceeds $50,000, the employee is taxed on any excess premium above this limit, as this amount is considered taxable annual income.
Group policy death benefit proceeds are similar to individual policies where the benefit is tax-free if taken as a lump-sum by the beneficiary. If installment benefits are chosen by the beneficiary, any interest earned on principal is considered earnings and is taxed accordingly.
Values Included in an Insured’s Estate
Upon the death of an insured individual in a life insurance policy, federal and state inheritance estate taxes are mandated for policy proceeds that are included in the estate of the insured.
To avoid this estate tax, the insured can transfer ownership of his or her life contract to the designated beneficiary, but the transfer must be completed at least three years before the death of the insured. Under the ‘three-year look back’ rule, the IRS can still levy estate taxes on the insured’s estate if a transfer of ownership to the beneficiary occurs within three years of the insured’s death.
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