E. Taxation of Life Insurance

Generally speaking, the following taxation rules apply to life insurance policies:

• Premiums are not tax deductible; and
• Death benefit: tax free if taken as a lump-sum distribution to a named beneficiary; principal is tax free, and interest is taxable, if paid in installments (other than as a lump sum).

1. Amounts Available to Policyowners

Permanent life insurance provides living benefits, and there are several ways in which policyowners may receive those benefits from the policy.

Dividends

Since dividends are a return of unused premiums, they are not considered income for tax purposes. When dividends are left with the insurer to accumulate interest, the interest earned on the dividend account is subject to taxation as ordinary income each year the interest is earned, whether or not it is paid out to the policyowner.

Cash Value Accumulations

Any cash value accumulated in the policy can be borrowed against by the policyowner, or paid to the policyowner upon surrender of the policy. Cash values grow tax deferred. Upon surrender or endowment, any cash value in excess of the cost basis (premium payments) is taxable as ordinary income. Upon death, the face amount is paid, and there is no more cash value — death benefits are generally paid to the beneficiary income tax free.

Policy Loans

The policyowner may borrow against the policy's cash value. Money borrowed against the cash value is not income taxable; however, the insurance company charges interest on outstanding policy loans. Policy loans, with interest, can be repaid in any of the following ways:

• By the owner, while the policy is in force;
• At policy surrender or maturity, subtracted from the cash value; or
• At the insured's death, subtracted from the death benefit.

Surrenders

When a policyowner surrenders a policy for cash value, some of the cash value received may be taxable as income if the cash surrender value exceeds the amount of premiums paid for the policy. When the owner withdraws cash value from a universal life policy (a partial surrender), both the cash value and the death benefit are reduced by the amount of the surrender.

Accelerated Benefits

When accelerated benefits are paid under a life insurance policy to a terminally ill insured, the benefits are received tax free. When accelerated benefits are paid to a chronically ill insured — for example, someone with cancer, Alzheimer's disease, or another severe illness — these benefits are tax free up to a certain limit. Any amount received in excess of this dollar limit must be included in the insured's gross income.

2. Amounts Received by Beneficiary

General Rule and Exceptions

Life insurance proceeds paid to a named beneficiary are generally free of federal income taxation if taken as a lump sum. An exception applies if the benefit payment results from a transfer for value — meaning the life insurance policy was sold to another party prior to the insured's death.

Settlement Options

With settlement options, when the beneficiary receives payments consisting of both principal and interest, the interest portion of the payments received is taxable as income.

3. Group Life and Employer-sponsored Plans

The premiums an employer pays for life insurance on an employee, where the policy is for the employee's benefit, are tax deductible to the employer as a business expense. If the group life coverage is $50,000 or less, the employee does not have to report the premium paid by the employer as income — it is not taxable to the employee.

Any time a business is the named beneficiary of a life insurance policy, or has a beneficial interest in the policy, any premiums the business pays for such insurance are not tax deductible. Therefore, when a business pays the premiums for any of the following arrangements, the premiums are not deductible:

• Key-employee (key-person) insurance;
• Stock redemption or entity purchase agreement; and
• Split-dollar insurance.

The cash value of a business-owned life insurance policy, or an employer-provided policy, accumulates on a tax-deferred basis and is taxed in the same manner as an individually owned policy.

Policy loans are not taxable to a business. Unlike an individual taxpayer, a corporation may deduct interest on a life insurance policy loan for loans up to $50,000.

Policy death benefits paid under a business-owned or employer-provided life insurance policy are received income tax free by the beneficiary, in the same manner as with individually owned policies.

If the general requirements for qualified plans are met, the following tax advantages apply:

• Employer contributions are tax deductible to the employer, and are not taxed as income to the employee;
• The earnings in the plan accumulate tax deferred; and
• Lump-sum distributions to employees are eligible for favorable tax treatment.

4. Section 1035 Exchange

In accordance with Section 1035 of the Internal Revenue Code, certain exchanges of life insurance policies and annuities may occur as nontaxable exchanges. When a policyowner exchanges a cash value life insurance policy for another cash value life insurance policy, or a cash value life policy for an annuity, or an annuity for an annuity, the policies or annuities must be on the same life. There will be no income tax on these transactions. The following are allowable exchanges:

• A life insurance policy for another life insurance policy, an endowment contract, or an annuity contract;
• An endowment contract for another endowment contract or an annuity contract; or
• An annuity contract for another annuity contract.

Note that a policyowner may not exchange funds from an annuity into a cash value life policy, nor would term life be used in a 1035 exchange, since it has no cash value. The key is that the exchange may not move from a less tax-advantaged contract to a more tax-advantaged contract. "Same to same" is acceptable.