Life insurance and taxes

The general rule is that life insurance death benefits received by a beneficiary are not subject to federal income tax.

Several exceptions and adjacent rules complicate that, and they arise more often than people expect.

Income tax on the death benefit

The general exclusion applies to amounts paid by reason of the death of the insured.

Points worth knowing.

Interest is taxable. If proceeds are held by the insurer and paid later with interest, or paid under a settlement option in installments, the interest portion is taxable.

Beneficiaries who leave proceeds with the insurer in an interest-bearing account receive taxable interest.

The transfer for value rule. If a policy is transferred for valuable consideration, the death benefit may become taxable to the extent it exceeds the consideration paid plus subsequent premiums.

There are exceptions — transfers to the insured, to a partner of the insured, to a partnership in which the insured is a partner, or to a corporation in which the insured is an officer or shareholder.

This matters in business succession arrangements and in life settlement transactions, and getting it wrong converts a tax-free benefit into a taxable one.

Estate tax

A separate matter from income tax, and the one people conflate.

If the deceased owned the policy, or held incidents of ownership in it, the death benefit is generally included in the gross estate for federal estate tax purposes.

Incidents of ownership include the right to change the beneficiary, to surrender the policy, to borrow against it, or to assign it.

Whether that inclusion produces tax depends on the size of the estate relative to the applicable exclusion amount, which is large under current law and which is scheduled to change.

Note also that a policy transferred within three years of death is generally brought back into the estate under a specific rule, which limits deathbed planning.

Irrevocable life insurance trusts

The standard structure for keeping proceeds outside the estate.

A trust owns the policy, is the beneficiary, and the insured has no incidents of ownership.

Premiums are typically funded by gifts to the trust, frequently structured to qualify for the annual gift tax exclusion using withdrawal rights — the arrangement commonly described by reference to a well-known court case.

The trust must actually be operated properly: the trustee must own and control the policy, notices must be sent, and the insured must not retain control.

This requires specialist drafting and ongoing administration. Done poorly, it fails to achieve the objective.

Cash value and policy transactions

Growth within the policy is generally not currently taxed.

Withdrawals from a policy that is not a modified endowment contract are generally treated as a return of basis first, tax-free up to total premiums paid, with amounts above that taxable.

Policy loans are generally not taxable while the policy remains in force.

The trap: if the policy lapses or is surrendered with an outstanding loan, the loan amount to the extent it exceeds basis is generally taxable as ordinary income.

This produces tax bills on money already spent, sometimes years earlier, and it happens to people who took loans in retirement and could not sustain the policy.

Surrender produces taxable income on the amount received above basis.

Modified endowment contracts, created by funding a policy too rapidly relative to its death benefit, are taxed differently — distributions including loans are taxed on a gain-first basis and may face an additional penalty before a specified age.

This classification is permanent once triggered.

Section 1035 exchanges

Allows exchange of one life policy for another, or for certain annuity contracts, without current tax, preserving basis.

Useful where a policy is underperforming or a different product is more suitable.

Caution: an exchange restarts surrender charges, may restart the contestability and suicide clause periods, and requires new underwriting for the new policy in most cases.

The rules on which exchanges qualify are specific — a life policy can be exchanged for an annuity, but not the reverse.

Employer-provided coverage

Group term life above a threshold amount produces imputed income to the employee, calculated using a published table.

Employer-owned life insurance on employees is subject to specific notice and consent requirements, and failing to meet them can make proceeds taxable to the employer.

Accelerated benefits

Amounts received under an accelerated death benefit or from a viatical settlement may be excluded from income where the insured is terminally or chronically ill as defined, and where the requirements are met.

Chronic illness acceleration has additional conditions including per-diem limitations.

The practical points

Check who owns each policy and whether that ownership creates estate inclusion.

Check beneficiary designations, which control regardless of the will.

Avoid naming the estate as beneficiary, which subjects proceeds to probate and to estate creditors.

Be very careful with policy loans in later life, and monitor whether the policy can sustain itself.

And get advice from a tax professional and an estate attorney rather than from the person selling the policy, whose expertise is in the product rather than in your tax position.

General information about United States tax concepts, not tax, legal or insurance advice. Rules are technical, depend on individual facts and are subject to change. Consult a qualified tax professional and estate attorney.