Insurance textbooks tell us that the primary purpose, if not the sole purpose, of property and casualty insurance is to indemnify the insured against physical and financial losses. In plain English, this means that the insured is supposed to be “made whole” but is not supposed to make any profit. There are only a few exceptions, such as property insurance issued in states that have “valued policy laws,” which require the insurer to pay the limit of coverage if there’s a total loss, even if the property’s value is less that the limit.
Arguably, but only arguably, replacement cost coverage is another exception. In any event, property and casualty insurance rarely if ever results in a gain or profit to the insured, so there is usually no income tax consequence when a claim or loss is paid, when an insured is provided a defense in a lawsuit, and so forth.
Life insurance, on the other hand, is an exception to the principle that insurance is a contract of indemnity. Who can place a precise value, such as “actual cash value” for example, on a human life? By necessity, the amount of life insurance payable on the death of the insured is a somewhat arbitrary measurement of the financial loss to his or her survivors. It may not even represent any financial loss, for example if an insured non-working spouse dies and the surviving spouse is the beneficiary, or if a wealthy person names a charity as the beneficiary of a policy on his or her life.
On the other hand, whole life insurance and other forms of cash-value life insurance have a substantial savings or investment element that can’t be ignored entirely if the tax laws are to operate fairly. So life insurance is subject to special rules regarding federal income taxation, and a separate set of rules regarding the federal estate and gift tax. The following is a summary of the most basic principles in each area. (References are to the Internal Revenue Code sections.)
1. The death proceeds of life insurance (face amount of the policy) are generally not taxable income to the beneficiary or beneficiaries. (Section 101(a)(1)). It doesn’t matter how long the policy has been in force, or how the amount of premiums relates to the amount of proceeds. So if the insured is 30 years old and has paid premiums for only a few years, or if the insured is 70 and has paid premiums for many years, the result is the same.
Although the proceeds may become part of the taxable estate for estate tax purposes, they are not considered income to the beneficiary, much in the same way as a gift is not considered income to the recipient (but may be subject to gift tax). The general rationale is that death proceeds, especially modest amounts, should simply not be taxed as income, and that large amounts are potentially subject to the estate tax.
Once the proceeds are received and invested, however, the interest or investment income is taxable. This applies even if the funds are left with the insurance company under a “settlement option,” such as an arrangement under which the beneficiary receives annual interest payments, or payment over a period of years (with interest built it), or payments under a life income option. (In the latter two cases, only part of each payment would be taxable. That is a whole subject in itself.) Also, the death proceeds can be taxable if the policy was “transferred for value,” meaning sold to another person for a valuable consideration, before the insured’s death. (This also is a subject in itself.)
2. The annual increases in the cash surrender value (CSV) of a life insurance policy are not taxable income as long as the policy is not surrendered. In technical terms, there is no “constructive receipt” of income, even though the policy owner has the right to withdraw the cash value at any time. For example, under a $100,000 policy issued at age 35, the cash value might increase by approximately $1,000 per year for the first 15 years or so, starting at the end of the second year.
Part of this increase is, of course, due to the premiums being paid, but part is also due to the insurance company’s investment earnings credited to the cash value. A major advantage of cash-value life insurance is the fact that this investment income is not currently taxed to the policyowner (tax-deferred), so long as the cash value remains untouched.
There are exceptions to this rule, which are quite complicated (see, if you dare, Section 7702, the definition of “life insurance,” and Section 7702A, which has to do with “modified endowment contracts” (MEC’s)). In a nutshell, if a policy fails to meet the statutory definition of life insurance or is an MEC, part of the death proceeds may be taxable or the build-up of the cash value may be taxable, or both. One easy-to-remember (but practically useless) rule is that any endowment before age 95 is treated less favorably than other kinds of cash-life insurance. (Virtually no endowments have been sold in the United States since the law was changed in 1984.)
3. The CSV of a life insurance policy actually received (i.e., taken in cash) during the insured’s lifetime is taxable under a “cost recovery” rule. (Section 72(e)). The excess of the CSV over the policy’s net cost (premiums minus dividends received in cash or applied to reduce the premium) is taxable as ordinary income (not capital gain) in the year in which the policy is surrendered. For example, if the premium has been $1,500 per year for 20 years ($30,000), the dividends have totaled $16,000 (paid in cash or used to reduce premiums), and the CSV is $29,000, the amount of income would be $29,000 minus $14,000, or $15,000. If dividends are accumulated with interest or used to purchase additions, they form part of the CSV and are therefore not deducted in the calculation.
In the case of variable life insurance, at least part of the increase in the cash surrender value is likely to be attributable to gains that might be taxed as long-term capital gains if they were not “inside” the life insurance policy. Nevertheless, upon surrender of a variable life policy, the gain (as calculated above) is treated as ordinary income rather than capital gain. An offsetting advantage is the fact that the policyowner can move funds from one sub-account to another and, in effect, “lock in” gains which are not taxable until the policy is surrendered.
4. Policy dividends are generally considered a tax-free partial refund of premium. (Section 72(e)(5)). Actuarially speaking, a life insurance policy dividend potentially consists of three elements: (1) lower-than-expected mortality experience (death claims), (2) greater-than-expected investment earnings, and (3) lower-than-expected expenses (home office, field expense, etc.). The premium contains a “loading” for these combined elements, part of which is returned if the company’s directors determine in their discretion, in retrospect, that it is not needed.
So in receiving a policy dividend, unlike a dividend on stock, the insured/policyowner is really just getting part of his or her own money back. However, if dividends are left to accumulate with interest, interest credited annually on the accumulated dividends is taxable as ordinary income. If dividends are “plowed back” into the policy by purchasing paid-up additions, in effect they earn investment income on a tax-deferred basis as part of the total CSV, which includes the CSV of the additions.
5. Unfortunately (for taxpayers), under current U.S. tax law, premiums paid for individual life insurance are generally not tax-deductible at all, regardless of income level or anything else, whereas they are given some favorable tax treatment in other countries (especially Europe and Japan). The rationale in other countries is based on the fact that endowments (see above) and other high cash-value policies are very popular there as retirement savings vehicles, and are therefore encouraged by the government.
6. The good news for U.S. employers is that the premiums for group term life insurance provided by an employer to employees are fully deductible as a business expense, with no specific limits on the amount of coverage that can be paid for as an employee benefit. (There are anti-discrimination requirements regarding “key employees,” however.) Also, the part of the premium attributable to a given employee (the value of the insurance, so to speak) is not taxable to the employee up to $50,000 of coverage. (Section 79 (a)).
The value of coverage in excess of $50,000 for any given employee is taxable income to that employee based on IRS Tables, regardless of the actual cost to the employer. For example, at ages 45-49 for either sex, the value is 15 cents per month per $1,000 of coverage. So a person aged 45 and covered for $150,000 (forget the first $50,000) would be subject to income tax on the value of $100,000 of coverage, which is $15.00 per month, or $180.00 per year.
7. Many policies issued in recent years contain Accelerated Death Benefit options which, despite their name, are not really death benefits. They allow the policyowner to receive all or a substantial portion of what would be the death benefit from the insurance company if the insured is certified to be terminally ill, or is certified to be chronically ill and uses the money for long-term care expenses.
The option for terminally ill insureds was initially developed in response to the creation of the viatical settlement industry, which allows approximately the same result but involves the purchase of policies from terminally ill persons by non-insurance firms on a case-by-case basis at a negotiated price. (The policyowner has a right to do this, and the company does not have to agree or consent.)
A terminally ill person is one who is expected to die within 24 months. A chronically ill person is one in need of long-term care services (defined with reference to certain Activities of Daily Living or ADL’s). In general, Accelerated Death Benefits and amounts received in viatical settlements are treated as non-taxable death proceeds. (Section 101(g)).
The death proceeds of life insurance are included in the “gross estate” of the insured (i.e., subject to taxation in the “taxable estate”) if: (a) the proceeds are payable to the insured’s estate; (b) the insured possessed one or more “incidents of ownership” (as defined in IRS regulations) at the time of death; (c) the insured made a gift of the policy within 3 years before the date of death; or (d) the insured transferred ownership of the policy for less than adequate consideration (and one of several other conditions is satisfied).
Under current law, depending on the size of the taxable estate, the federal estate tax starts at 18% and rapidly goes up to 49% as of 2003. There is an exempt amount which goes from $1,000,000 in 2003 in stages up to $3,500,000 in 2009. Then the tax disappears entirely for one year, 2010; then it comes back into effect in 2011, basically as it was in 2002. (This can never realistically happen, so the law must be viewed as temporary.)
Because of the unlimited marital deduction (the deduction of a sum of money from the gross estate), life insurance proceeds payable to a surviving spouse are entirely free from estate tax, as well as income tax.
Copyright 2003 by Peter Lencsis. Used with permission.