Income Tax Treatment of Life Insurance

Understanding how life insurance is treated for income tax purposes is essential for both producers and policyowners. Life insurance enjoys significant tax advantages that make it a valuable financial planning tool.

Death Benefit Taxation

General Rule: Tax-Free Death Benefits

Under IRC Section 101(a), life insurance death benefits received by a beneficiary are generally excluded from gross income. This is one of the most significant tax advantages of life insurance.

Example: John's beneficiary receives a $500,000 death benefit. The entire $500,000 is received income tax-free, regardless of how much premium was paid.

The Transfer for Value Rule

The transfer for value rule is a critical exception to the tax-free death benefit rule. When a life insurance policy is transferred for valuable consideration, the death benefit may become partially taxable.

Formula for Taxable Portion:

Taxable Amount = Death Benefit - (Consideration Paid + Premiums Paid by Transferee)

Example:

• Policy transferred for $50,000
• Transferee pays $25,000 in subsequent premiums
• Death benefit: $500,000
• Taxable amount: $500,000 - $50,000 - $25,000 = $425,000

Exceptions to Transfer for Value Rule

The death benefit remains tax-free if transferred to:

1. The insured - The policyholder can buy back their own policy
2. A partner of the insured - Business partner exception
3. A partnership in which the insured is a partner
4. A corporation in which the insured is a shareholder or officer
5. A transferee whose basis is determined by reference to the transferor's basis - Includes gifts and tax-free exchanges

Exam Tip: The transfer for value rule does NOT apply to gifts. If you gift a policy, the death benefit remains income tax-free to the beneficiary.

Cash Value Accumulation

Tax-Deferred Growth

The cash value inside a life insurance policy grows tax-deferred. The policyowner pays no income tax on:

• Interest credited to the cash value
• Dividends reinvested in paid-up additions
• Investment gains in variable life policies

This tax-deferred growth is similar to retirement accounts but without contribution limits.

Policy Loans

Generally Not Taxable

Policy loans are generally not taxable events because:

• They are considered loans, not distributions
• The policy serves as collateral
• No actual withdrawal of funds occurs

Warning: If a policy lapses or is surrendered with an outstanding loan, the policyowner may face a significant tax liability even though no cash is received.

Surrenders and Withdrawals

FIFO Taxation for Non-MECs

For policies that are NOT Modified Endowment Contracts, withdrawals follow First-In, First-Out (FIFO) treatment:

1. Withdrawals come from cost basis first (premiums paid)
2. Only amounts exceeding basis are taxable as ordinary income
3. This makes partial withdrawals favorable for accessing cash

Example - Non-MEC Withdrawal:

• Total premiums paid (basis): $50,000
• Current cash value: $75,000
• Withdrawal: $30,000
• Tax consequence: $0 (withdrawal doesn't exceed basis)

Basis Calculation:

Cost Basis = Total Premiums Paid - Dividends Received + Loan Interest Capitalized

Complete Surrender

When a policy is completely surrendered:

Taxable Gain = Cash Surrender Value - Cost Basis

Any gain is taxed as ordinary income, not capital gains.

Example - Full Surrender:

• Cash surrender value: $100,000
• Total premiums paid: $60,000
• Taxable gain: $40,000 (taxed as ordinary income)

1035 Exchanges

Section 1035 allows tax-free exchanges between certain insurance products:

Exam Tip: You can go "down" from life insurance to an annuity tax-free, but you cannot go "up" from an annuity to life insurance without triggering taxes.