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Taxation of Life Insurance Products
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Tax Treatment of Premiums Premiums paid for any individual life insurance policy are a personal expense and are not tax-deductible. Premiums paid to fund Group Life insurance plans are tax-deductible by the employer; and generally, employees covered under a group life plan are not taxed on benefits received from group insurance, there is one exception: Employer-paid premiums for group life insurance coverage in excess of $50,000 are considered taxable income to the employee.
Tax Treatment of Cash Accumulation The growth of a life insurance policy’s cash value accumulates on a tax deferred basis. Tax Treatment of Policy Dividends In a participating policy, dividends paid to the policy owner are considered by the IRS to be a return of excess premium and are not taxable. In a non-participating policy, dividends are paid to stockholders and are taxable.
Tax Consequences of a Life Insurance Policy Withdrawal or Surrender Withdrawal of life insurance cash value is not taxable as long as the cash value does not exceed the sum of all premiums paid (cost basis). If cash value does exceed cost basis, any withdrawal from a life insurance policy will be considered first a return of interest and represent taxable income. Only after all interest earnings are paid will withdrawals be considered a tax-free return of principal.
Tax Treatment of Policy Loans Policy loans are an important feature of any whole life policy. When a policy loan is made by the insurer, it is done so with interest, but is not a taxable event. Note: Insurers have the right to defer a request for a loan, withdrawal or cash surrender up to six months.
A business cannot deduct the premiums paid for key person, executive bonus insurance or insurance purchased on the lives of the business owners to fund a buy/sell agreement or disability buy-out, but can exclude any benefits received from its gross taxable income. Benefits paid to a deceased partner's estate in excess of amounts required to fund a buy/sell agreement, or the deceased partner's cost basis in the business may be taxable to the deceased partner's estate.
Tax Treatment of Death Benefits The IRS generally excludes life insurance policy proceeds from the beneficiary's gross income. This is perhaps the most significant tax advantage of life insurance. It allows a person to provide for the economic security of a spouse or business associate without concern of creating an income tax liability for the beneficiary.
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Tax Treatment of Annuity Contributions Premiums are not tax deductible, but there is no maximum contribution to an annuity. Tax Treatment of Cash Accumulation All growth in an annuity is tax deferred until withdrawn.
Tax Consequences of a Withdrawal Any withdrawal from an annuity will be considered first a return of interest and represent taxable income. Only after all interest earnings are paid will withdrawals be considered a tax-free return of principal.
Withdrawals made before age 59 ½ will also be subject to a 10% IRS penalty. The only way to avoid this penalty is to annuitize. Note: For the purpose of this exam there is no such thing as a tax-free loan from an annuity. Taxation of annuity payments differs from withdrawals during the accumulation stage. The 10% penalty does not apply to an annuity contract that has been annuitized, regardless of the annuitant’s age.
When an annuitant receives an annuity payment, the tax liability is in direct proportion to the percentage of the payment attributable to growth. The exclusion ratio is the amount of an annuity payment that is not subject to income tax when received, since it is considered to be the return of the original principal. The monthly payment for a fixed annuity will not change but the payment can change for variable annuities, reflecting the investment experience of the principal.
The IRS accommodates for portability of funds in life insurance and annuity contracts. Internal Revenue Code 1035 allows the transfer of funds from one product to another or from one company to another. Under 1035 exchange rules, tax on accumulated earnings will be deferred for the following transfers: • Life Insurance Policy into another Life Insurance Policy • Life Insurance Policy into an Annuity • Annuity into another Annuity Note: It is not possible under rule 1035 to exchange an annuity into life insurance.