Two Sure Things-Death and Taxes Q and A

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by Steve Goodman

CPA, MBA – President & Chief Executive Officer

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Are taxes paid on policy distributions?

Taxes are only paid on distributions (dividends, withdrawals, and partial surrenders) that exceed the amount of the policy owner’s investment in the policy.

Are taxes paid on policy loans?

No, because loans are not considered to be distributions from the policy, unless the policy lapses.

What are the tax implications if there’s an outstanding loan on a lapsed policy?

Any outstanding loans and accrued interest are assigned to the policy owner for tax purposes upon lapse. If this amount, plus residual cash value, exceeds the owner’s cost basis, it’s considered taxable income. If there is a large loan balance, the taxable income can be substantial, with no corresponding surrender value.

What are the tax implications if a policy with an outstanding loan is gifted?

If the loan and any unpaid interest exceed the owner’s cost basis, the gift is considered to be a part-sale transaction and the owner is taxed on the portion of the policy sold to the extent of the gain. The policy is also considered to have been transferred for valuable consideration and the beneficiary will be taxed on a portion of the death benefit received.

How do you calculate a life insurance policy’s cost basis?

Cost basis is how much a policy owner has invested in a policy. Premium payments increase cost basis while distributions decrease cost basis. Note that dividends used to reduce premiums or buy paid-up additions generally do not impact the investment in the policy — generally, net premiums paid out of pocket increase the cost basis.

What are the tax implications of a policy surrender?

The amount of gross surrender proceeds (cash, policy loans, and accrued interest) that exceeds the owner’s cost basis is considered taxable income to the policy owner.

Are there tax benefits if a policy is surrendered or lapses and the cost basis is higher than the surrender value or lapsed proceeds?

No, because life insurance is a personal asset, not an investment, so losses aren’t deductible.

Is policy loan interest deductible?

No.

Are donations of life insurance policies to charitable organizations deductible?

A: Yes, but with provisions. Interested readers are advised to see the article ‘Life Insurance – Even Giving It Away Can be Complicated’ in the Life Insurance section of this website for additional information. This is an area with significant tax complexities. Readers are advised to consult a tax advisor if this is under consideration.

What are the tax implications if the insured survives to the policy’s maturity date?

Withdrawals of policy values up to the owner’s cost basis can be made without any tax implications. Meanwhile, loans can be taken for amounts that exceed the cost basis, and mature policies surrendered for maturity value are taxed like any other surrender.

What is a Modified Endowment Contract (MEC) and how are MEC distributions taxed?

A MEC is a special type of insurance policy that doesn’t receive some of the tax benefits that non-MEC policies do. MEC policies are generally taxable as a distribution of earnings to the extent of the gain. Collateral assignments and loan pledges are treated as distributions. Note that an additional 10% penalty applies to premature distributions of income unless the policy owner is 59½ years old or older or is disabled.

Do MEC policy values grow tax-deferred?

Yes, assuming that policy values aren’t borrowed or withdrawn.

Are MEC death benefits taxable?

No, with two possible exceptions: transfers for value and employer-owned life insurance.

What is a 1035 exchange?

This enables policy owners to exchange one life insurance policy for a different policy (or a long-term care policy or annuity contract) without recognizing a gain or loss. To qualify for a 1035 exchange, an annuity contract can be exchanged for a different annuity contract or long-term care policy, and a long-term care policy can be exchanged for another long-term care policy. Also, the insured and the policy owner must be the same in both the old and new policies, so policy ownership can’t be changed. Annuities cannot be exchanged for life insurance policies using a 1035 exchange. What are the tax implications of a 1035 exchange?

A policy owner’s cost basis is transferred to a new policy without the recognition of a taxable gain or loss.

What if there is an outstanding loan on the policy being exchanged?

Some insurers will allow an outstanding loan to be carried over to the new policy, in which case there is no taxable loan payoff. If the loan is paid off instead, either the gain in the policy or the amount paid off is taxable, whichever is less.

Are there any special rules for survivorship policies when it comes to 1035 exchanges?

Since the insured individual(s) must be the same for an exchange to qualify for Section 1035 treatment, a policy on the life of a single insured individual can’t be exchanged for a policy on the life of two different insured individuals, and vice versa. With a second to die policy, once the first insured individual dies, the policy can be exchanged for a new policy on the surviving individual’s life.

If the transfer-for-value rule has been violated, can this be fixed after the fact?

This can be fixed with a subsequent transfer, subject to an exception, in order to clear the previous transfer for value.

 

Steve

CPA, MBA – President & Chief Executive Officer

About Steve Goodman

For more than 30 years, Steven has provided insightful solutions to the challenges of business succession, wealth preservation and charitable planning, focusing on the needs of owners of closely held businesses and high net worth individuals.

He's been featured in the New York Times and is an accomplished speaker and has presented over the years to many organizations and professional groups on efficient business succession, estate planning issues and tax strategies. Steven is a CPA who was vice president of the Trust and Investment Division of JP Morgan Chase and a supervisor for KPMG Peat Marwick, and holds an MBA from Fordham University.

Email Steve today for the business succession planning you deserve.

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Steve

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CPA, MBA – President & Chief Executive Officer

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