Alyssa Lane
Life insurance policies can be a great way to provide financial security for your family, but it's important to understand the tax implications to avoid unexpected costs. The cost basis of a life insurance policy is the total amount of premiums paid into the policy by the policyholder, representing their investment in the policy. When a policy is surrendered or matures, its cash value exceeding the owner's cost basis is taxable as ordinary income. Withdrawals from a policy are treated as a return of the cost basis, and only the amount exceeding the cost basis is subject to income tax. Understanding the tax basis of your life insurance policy is crucial for making informed decisions and ensuring compliance with tax laws.
Characteristics and Values of Tax Basis in Life Insurance
| Characteristics | Values |
|---|---|
| Cost Basis | The cumulative amount of premiums paid into the life insurance policy by the policyholder. It represents the total investment made by the policyholder over the policy's life. |
| Taxable Amount | The taxable amount is based on the type of income document received, such as a Form 1099-INT or Form 1099-R. |
| Tax Treatment | Life insurance is treated as a personal asset, and losses resulting from the sale or disposition of personal assets are not deductible. |
| Modified Endowment Contract (MEC) | Policy loans and/or distributions are taxable if the policyowner is under 59 1/2. Accessing cash values through borrowing or partial surrenders may result in a tax liability if the policy terminates before the insured's death. |
| Policy Distributions | Dividends, withdrawals, or partial surrenders from a life insurance policy are first treated as a return of the cost basis. Only distributions that exceed the policy's cost basis are subject to income tax. |
| Reportable Policy Sale | The Tax Cuts and Jobs Act of 2017 added a new category to the transfer-for-value rules, and exceptions may not apply. |
| Tax-Free Exchange | A tax-free exchange occurs when one life insurance policy is exchanged for another under specific conditions, such as the exchange being a single, integrated transaction and the insured and owner remaining the same. |
| Taxable Income | If the proceeds from the policy sale exceed the cost basis, the difference is considered taxable income and may be subject to capital gains tax. |
| Surrender of Policy | When a policy is surrendered or matures, its cash values exceeding the owner's cost basis are taxable as ordinary income. |
| Life Insurance Benefits | Generally, life insurance benefits at death are not subject to income tax, except in certain circumstances. |
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What You'll Learn
Cost basis of a life insurance policy
The cost basis of a life insurance policy is the owner's investment in it. It is the total net out-of-pocket premium payments made, minus any non-taxable withdrawals. It does not include premiums for accidental death, waiver of premium, disability benefit riders, or loan interest paid. The cost basis of a life insurance policy can be affected by various factors, such as the amount and frequency of premiums paid, any loans or withdrawals taken against the policy, and any dividends or interest credited to the policy.
When a life insurance policy is surrendered (cashed in) or matures, its cash values are taxable as ordinary income to the extent that they exceed the owner's cost basis in the policy. Generally, any loss incurred in connection with the surrender of a life insurance policy is non-deductible as a personal expense. When a policy is sold in the secondary market, the seller is taxed on the difference between the selling price of the policy and the seller's cost basis. This is the case unless the policy is a Modified Endowment Contract (MEC), in which case, withdrawals are taxed as income once the entire cost basis has been withdrawn.
If a policy is terminated for any reason other than the death of the insured, any outstanding loan is taxable to the extent that there is a gain in the policy. This gain is calculated as the cash surrender value plus the outstanding loan, less the cost basis. In a term policy, all gains will be treated as capital gains, as there is no cash value buildup for the ordinary income treatment to apply to.
It is important to note that life insurance benefits at death are generally not subject to income tax, except in a few key circumstances. For example, if the death benefit is reduced within the first 15 years of the policy, it may cause cash to be distributed to qualify as life insurance, and this may be subject to income tax. Additionally, if a policy is exchanged or lapses with a loan still outstanding, the outstanding loan may be subject to tax if there is a gain in the policy.
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Tax-free exchange
A 1035 exchange is a provision in the Internal Revenue Service (IRS) code that allows for a tax-free transfer of an existing annuity contract, life insurance policy, long-term care product, or endowment for another of its kind. This means that a life insurance policy can be exchanged for a non-qualified annuity, but a non-qualified annuity cannot be exchanged for a life insurance policy. The 2006 Pension Protection Act (PPA) modified IRC section 1035 to include exchanges from life insurance policies and non-qualified annuities into traditional and hybrid qualified long-term care products.
The primary benefit of a 1035 exchange is that it lets the contract or policy owner trade one product for another without tax consequences. However, despite the tax benefits, 1035 exchanges do not absolve contract owners of their obligations under the original contract. For example, insurance companies typically don't waive surrender charges for 1035 exchanges. The exchange must be reported on the individual's annual tax return using Form 1099-R.
The tax code says that the old insurance policy must be exchanged for a new policy—funds cannot be withdrawn and used to purchase a new insurance policy. The money must be transferred directly. The annuitant or policyholder must also remain the same. For example, a 1035 exchange from an annuity owned by Joe Sample cannot be exchanged for an annuity owned by Jane Sample or a joint annuity owned by Joe and Jane Sample.
There are some important considerations to keep in mind when contemplating a 1035 exchange. Firstly, the exchange is only tax-free if it is between similar products. Secondly, the original contract obligations are not absolved, and surrender charges may still apply. Finally, the exchange must be reported on the individual's tax return, and the transferring company will issue a 1099-R form to record the transaction.
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Modified endowment contracts
A modified endowment contract (MEC) is a cash value life insurance policy that has lost its tax benefits because it contains too much cash. The MEC came about in the 1980s after many policyholders took advantage of the fact that the cash value portion of their policies could grow tax-free. Insurers added features to pump up that perk (and sell more insurance).
Today, for a life insurance policy to become an MEC, it must meet three criteria: you purchased the policy on or after 21 June 1988; your policy meets the definition of a life insurance policy; and the policy exceeds the premium payment limits as defined by the IRS. The IRS uses the \"seven-pay\" test to determine whether to convert a life insurance policy into an MEC. If you put too much money into your policy in the first seven years, it becomes an MEC. The MEC limits for a policy depend on its terms and death benefit amount.
Once the Internal Revenue Service (IRS) relabels your life insurance policy as an MEC, it loses the tax breaks for withdrawals and loans that you make from the policy. This permanent change can happen when you pay excess premiums in too short a period. Permanent life insurance contracts in general are granted generous tax advantages in the US, but if you put too much cash into one, it loses its status as "insurance" and becomes an investment vehicle.
A major disadvantage posed by an MEC for most policyholders is that withdrawals are taxed and possibly penalized if early, similar to those taken from non-qualified annuities. MECs may be useful for some because they often offer a better low-risk yield than savings accounts do and can ease asset transfer upon the owner's death.
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Surrendering a life insurance policy
There are two main downsides to surrendering a life insurance policy. Firstly, you lose your life insurance protection. Secondly, you may have to pay fees and lose some of your cash value. Surrender fees typically apply if your policy isn't very old, and they diminish with time, so the longer you've had your account, the less you'll have to pay.
If you surrender your policy, you may receive a payout, but this may be subject to tax. The amount of the sale proceeds in excess of your basis in the policy will be treated as ordinary income up to the policy's cash surrender value, and any proceeds in excess of this value will be treated as capital gain. The cash surrender value is the amount of cash you've built up minus any surrender charges or fees. This value is usually paid in a lump sum, but you may receive periodic payments over time, depending on your policy.
There are other options to access your cash value if you want to keep your life insurance protection. In most situations, you can take a cash withdrawal from your permanent life policy, and this will not be subject to income tax if it's less than the amount paid into the policy. Alternatively, you could borrow from the whole life insurance policy, using the policy as collateral.
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Taxable and non-taxable income
Life insurance proceeds are generally not taxable, but there are certain situations where taxes may apply. Here is an overview of the taxable and non-taxable aspects of life insurance:
Non-taxable Income:
- Death Benefits: Typically, the death benefit paid to beneficiaries is not taxed as income. They can receive the full amount to cover expenses without reporting it as taxable income.
- Long-term Care Insurance Reimbursements: Payments received from qualified long-term care insurance contracts as reimbursement for medical expenses due to personal injury or sickness are generally excluded from taxable income.
- Accelerated Death Benefits: Certain payments received under a life insurance contract on the life of a terminally or chronically ill individual (accelerated death benefits) are also usually excluded from taxable income.
Taxable Income:
- Interest on Death Benefits: If the beneficiary receives the death benefit in installments, the gains made from interest may be considered taxable income.
- Withdrawals Exceeding Basis: Withdrawals from a life insurance policy that exceed your cost basis (the total amount of premiums paid into the policy) are generally taxable. The portion that is up to your cost basis is tax-free, but anything above that is considered taxable income.
- Modified Endowment Contracts: Policy loans and/or distributions from Modified Endowment Contracts are taxable if the policyowner is under 59½. Additionally, withdrawals are treated as taxable income until they equal all interest earnings in the contract.
- Surrender of Policy: Surrendering a permanent policy may trigger taxes. If you surrender your policy to the insurance company, the difference between the amount received and your basis in the policy will be taxable as ordinary income.
- Policy Sale to Third Party: If you sell your life insurance policy to a third party at a profit, the amount exceeding your basis in the policy will be treated as ordinary income, and any amount above the policy's cash surrender value will be treated as a capital gain.
- Interest on Dividends: Interest credited to a dividend accumulation account is currently taxable to the policyowner.
- Accident and Health Insurance from Employer: If you receive disability payments through an accident or health insurance plan partially or fully paid for by your employer, the amount attributable to your employer's payments must be reported as income.
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Frequently asked questions
The cost basis of a life insurance policy is the cumulative amount of premiums paid into the policy by the policyholder. It represents the total investment made by the policyholder over the policy's life. Net out-of-pocket premium payments increase the cost basis, while non-taxable withdrawals reduce it.
Yes, surrendering your permanent life insurance policy can have tax implications. The cash surrender value (CSV) is the amount you will receive after any fees are deducted. If the CSV is higher than the amount of premiums you've paid into the policy (your cost basis), the excess is taxable as ordinary income.
The IRS will only tax the portion that exceeds your cost basis (the total amount of premiums you've paid into the policy). The withdrawal amount up to your cost basis is tax-free, but anything above that is considered taxable income and will need to be reported.
No, the tax law does not treat life insurance as an investment asset. It is treated as a personal asset, and losses resulting from the sale or disposition of personal assets are generally not deductible.
