Variable Life Insurance Taxation

Variable life insurance has significant tax advantages, including tax-deferred growth and potentially tax-free death benefits. However, certain situations can trigger unfavorable tax treatment, particularly involving Modified Endowment Contracts (MECs).

Key Tax Advantages of Variable Life

FIFO Taxation for Withdrawals

Unlike annuities (which use LIFO), life insurance uses First-In, First-Out (FIFO) treatment for withdrawals:

FIFO Rule: Withdrawals are considered a return of basis (premiums) FIRST, tax-free until all basis is recovered.

FIFO Example

If the owner withdraws $20,000:

• Entire $20,000 is tax-free (return of basis)
• Remaining basis = $30,000
• This is more favorable than annuity taxation!

Exam Tip: Life insurance uses FIFO (Basis first). Annuities use LIFO (Earnings first). This is frequently tested!

Comparison: Life Insurance vs. Annuity Taxation

Tax-Free Death Benefit

Life insurance death benefits are generally income tax-free to beneficiaries under IRC Section 101(a):

• Full death benefit received free of income tax
• No step-up in basis needed (already tax-free)
• May be subject to estate tax if policy owned by deceased

Key Point: This is a major advantage of life insurance over annuities, where the earnings portion of death benefits IS taxable to beneficiaries.

Policy Loans

Policy loans from non-MEC life insurance are generally tax-free:

• Not considered withdrawals for tax purposes
• Interest accumulates but isn't deductible
• Outstanding loans reduce death benefit
• If policy lapses with outstanding loan, taxable event occurs

Warning: If a policy with an outstanding loan lapses or is surrendered, the loan amount may become taxable to the extent it exceeds basis.

Modified Endowment Contracts (MECs)

A Modified Endowment Contract (MEC) is a life insurance policy that fails the IRS "7-pay test" and loses many tax advantages.

The 7-Pay Test

The 7-pay test checks if cumulative premiums paid in the first 7 years exceed the amount needed to pay up the policy in 7 level annual payments.

Fail the 7-Pay Test = MEC

What Triggers MEC Status?

Key Point: A single-premium life insurance policy is AUTOMATICALLY a MEC.

MEC Tax Consequences

Once a policy becomes a MEC, the tax treatment changes dramatically:

MECs are taxed like annuities - LIFO treatment, loans taxable, 10% early withdrawal penalty.

MEC Status is Permanent

Critical: Once a policy becomes a MEC, it cannot be "cured" or reversed. It remains a MEC for the life of the policy.

The 60-Day Grace Period

The IRS allows a 60-day grace period for insurance companies to return excess premiums:

• If overpayment is returned within 60 days, MEC status may be avoided
• After 60 days, MEC status is permanent

When MEC Status Might Be Acceptable

Despite tax disadvantages, MECs may still be appropriate when:

• Policy is primarily for death benefit (not cash access)
• Owner doesn't plan to take loans or withdrawals
• Estate planning purposes
• Owner wants maximum death benefit from single premium

Tax Treatment Summary Table

Estate Tax Considerations

While death benefits are income tax-free, they may be included in the deceased's estate for estate tax purposes if:

• Deceased owned the policy at death
• Deceased had "incidents of ownership" (ability to change beneficiary, borrow, etc.)
• Policy was transferred within 3 years of death

Solution: Irrevocable Life Insurance Trust (ILIT) can remove policy from estate.

Policy Exchange (1035)

Life insurance policies can be exchanged tax-free under Section 1035:

MEC Status Carries Over: If you 1035 exchange a MEC to another life policy, the new policy is also a MEC.

Key Exam Points

1. Life insurance uses FIFO - Basis comes out first, tax-free
2. Death benefits are income tax-free - Major advantage over annuities
3. Policy loans are tax-free - Unless MEC or policy lapses
4. 7-pay test failure = MEC - Changes tax treatment permanently
5. MECs use LIFO - Like annuities, earnings taxed first
6. Single premium policies are always MECs
7. MEC status cannot be reversed