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Taxation of Life Insurance

Tax laws do change and we do not update this page daily, so be cautioned. You are counseled to see your tax advisor before using any of these suggestions. Not all situations are the same from person to person.

• Life insurance premiums are not tax-deductible. The only exception is the premiums paid by an employer for the benefit of employees in a group life policy.

• Generally, death proceeds are not subject to federal income tax when received by the beneficiary. There are minor exceptions to this rule and generally only apply when a non-group policy is transferred to an employee/owner under the "transfer-for-value" rule.

• The proceeds will be included in the estate of the owner for federal estate tax purposes should the policy be owned by the insured. Certain credits do apply and proper planning can minimize (or even eliminate) this estate tax problem. To properly eliminate the life insurance proceeds from the estate of the owner, there must be no "incidents of ownership" by the insured. An in-force policy that is transferred to an irrevocable trust will still be included in the estate of the owner if death occurred within three years of the transfer.

Cash values grow tax deferred until received (first in, first out - FIFO). When cash values are withdrawn, those that exceed the premium outlay are subject to ordinary income tax. Cash values that are paid in addition to a death benefit, such as Option B in Universal Life, are considered death benefits and are not normally subject to income tax.

• Example of FIFO, as it relates to life insurance cash value:

• Over the years the insured has paid premiums totaling $7,000 to his universal life policy. His policy has $8,000 in cash values. The insured needs to take all $8,000 due to an emergency and cancel, cash surrender, his policy. The first $7,000 of his withdrawal will be considered a tax-free return of premium (First In, First Out) and the balance will be taxed as ordinary income. Taxation of income earned that exceeded the paid premiums was deferred until actual distribution. Had he taken a loan, as required in the case of a Whole Life policy, federal income tax would not be due in this tax year. The tax is deferred to a later date, and if death occurs before the tax is due, then no tax is imposed.

NOTE: A loan would have to be less than the full $8,000 so as to keep the policy in force. Any full surrender with cash value greater than basis, the total premium paid, will create a taxable event.