Naturally, one of the core benefits of life insurance are the tax advantages policies can provide. However, tax advantages change depending on how the value of a life insurance policy is accessed (i.e. tax policies are different if your heirs receive the death benefit as opposed to if you access the cash value), who owns the policy, and whether a policy even qualifies as “life insurance” in the first place.
In this article, we are going to briefly discuss the different taxation measures associated with life insurance, and why they are important to have a basic understanding of whenever you are looking to take out a life insurance policy. The goal is to break down these otherwise complex and technical concepts into an understandable format for engaging with life insurance options and their subsequent tax implications.
Given the original and core purpose of life insurance, tax policies surrounding the death benefit are typically one of the most important considerations in taking out a life insurance policy.
In general, death benefits are considered income tax free under federal tax laws, with the beneficiaries receiving the value of the death benefit as non-taxable income.
However, as always, there are some stipulations and regulations on this, and death benefits can become partially or fully taxable based on individual policy circumstances.
The most common situation in which death benefits become taxable is if the policy fails to meet the definition of life insurance, which has been defined by the federal government.
Due to the tax advantageous nature of life insurance policies, and the desire to utilize them as a tool to realize financial gains, the federal government has defined two ways in which life insurance policies can be “tested” to ensure they meet the definition of “life insurance”. This limits the ability for individuals to use them as a tax-haven for investments.
The purpose of this article is not to dive into the nitty-gritty details of federal tax code and policies, however, in order that you may have a foundational understanding of what life insurance is, we will briefly consider the two tests. The choice of one of these two tests, which must be declared at the policy's inception and cannot be changed later on, provides different benefits to the policy holder. However, this is a problem that usually only comes up with regards to universal life insurance, as opposed to whole life insurance.
The cash value accumulation test (CVAT) simply ensures that the cash value of a life insurance policy (in cases of whole life and universal life insurance, this is the part of your policy which you are able to withdraw or borrow against) does not exceed the present value of all future premium payments owed on the policy. All whole life insurance policies are tested under CVAT.
In the simplest terms possible, CVAT establishes a necessary gap between the value of the surrender cash value of the policy and the death benefit, where the surrender cash value cannot exceed a federally specified percentage of the death benefit. This shrinks as the age of the insured individual increases - it can even hit 0% eventually.
The CVAT test is best for policyholders who want to maximize the death benefit of the policy and who do not want to be limited in the amount of premiums they can pay into the policy.
The guideline premium and corridor test applies to universal life insurance policies in which the premium is split into two portions: one portion towards the cost of the policy and the other towards a cash accumulation account.
The reason why this matters is life insurance policies can be tailored to take full advantage of two different components: the cash value or the death benefit.
The GPT test comes into play in two instances. The first instance is when a specific policyholder desires to pay the maximum amount in premiums while at the same time maintaining a variable death benefit. The second instance is when a policyholder desires to maximize the cash accumulation of the policy, as opposed to maximizing the death benefit.
The GPT test itself has two important components:
Transferring or selling your policy typically results in the policy then being taxable, after deduction of the policy's cost basis - this is known as the “Transfer-for-Value” rule.
If you sell your policy, it typically becomes taxable, however, this is usually not relevant to the policyholder, since the purchaser is then responsible for these taxes.
However, where it can become relevant is when the transfer of the policy is made to an individual with an insurable interest in the life of the insured’s life (i.e. someone with a familial or financial relationship with the insured), which is not uncommon. Assuming the individual who receives the transfer of the policy gave some form of valuable consideration (this does not have to be through the exchange of cash or some other valuable such as property and can be as simple as an exchange of promises), then the policy will be subject to taxation for proceeds above and beyond the cost basis.
If the policy is given as a gift, then tax implications would be incurred in accordance with the gift tax and associated exemptions (a more detailed explanation of the gift tax can be found in the discussion of Recent Changes in the Taxation of Life Insurance below).
Another instance in which the policy can become subject to taxation is through estate taxation. This sort of taxation can be triggered in two ways.
The first instance is if the estate is named as the beneficiary of the death benefit, in which case the entire amount of the death benefit would be included in the estate and subject to the estate tax.
The second instance in which the death benefit could be subject to estate taxation is if the insured, who would now be deceased, owned the policy themselves.
The first instance is typically less relevant, since it is usually unlikely that an individual would be insured and not name beneficiaries - thus it does not become part of the estate. The main issue that comes up is with regards to the second instance described: namely ownership of the policy. Remember, the owner of the policy is not always the individual who is being insured - it is quite common for individuals to purchase life insurance policies on the life of their spouse or parents.
It is important to understand that the proceeds of the death benefit of life insurance are income tax free, but this does not mean they are estate tax free. Under this second scenario, in which the insured has incidents of ownership, life insurance policies then become subject to the estate tax. Therefore, the only way to avoid this is to transfer the policy to the ownership of someone else or some other entity. They then become responsible for the payment of the premium and have full decision making power over the policy. Additionally, this transfer must take place at least 3 years before the insured’s death.
Naturally, this starts to get into the weeds of estate planning, which is beyond the scope and frame of this discussion. However, these potential tax implications are something to keep and mind and understand at least on a foundational level, and they are something to consider and think about when the time comes to start drawing up plans for your estate, particularly for high net worth individuals who may be subject to higher estate tax brackets.
Aside from the death benefit, whole and universal life insurance policies also have an accumulated cash value. This can also be subject to taxation under certain circumstances.
As the cash value accrues, these increases are typically not subject to any form of income taxation, so long as the policy meets the definition of life insurance, as previously detailed. If the policy does not meet the definition of life insurance, you would then be responsible for paying taxes on the annual increase in cash value. This would then be subject to further differentiation based on how the account was accumulating its value - however, the main takeaway is that it would be subject to taxation.
If you choose to surrender the policy and take the cash surrender value, then you would be subject to taxation. It is important to note that surrender proceeds are taxed as ordinary income. They are not taxed as capital gains.
Your cost basis would then typically be calculated as the total value of the premiums you paid into the policy minus the cumulative value of any untaxed distributions (typically withdrawals or dividends) paid out by the policy. If you took out any loans on the policy, these can also have an impact on the taxation of the policy, though they usually don’t. The way you elect to then receive this cash value (i.e. some policies allow for you to then have an annuity) can also impact the tax implications on the surrender value.
It is also important to note that, in order to disincentivize the purchasing of life insurance as an investment by which to profit, any losses you incur in relation to the sale of the policy or the surrender are not deductible.
This is often one of the big initial questions about life insurance premiums. Unfortunately, the answer is that most life insurance premiums are not tax deductible. There are a few instances where premiums are tax deductible, but they generally do not apply to individuals.
Examples of instances where life insurance premiums are tax deductible include businesses that pay the premiums on a policy payable to the employee as a form of bonus, premiums paid on a policy both owned by and payable directly to a charity, and premiums paid as part of an alimony patent. However, generally, for individuals taking out life insurance, premiums are not tax deductible.
Life insurance policies that include an “accelerated death benefit” allow policyholders to access their death benefit prior to their death in circumstances of ill health. It is an option designed to allow people to have a level of financial security in the last few months of their life if they need to pay for medical care.
Accelerated death benefits, as well as payments associated with long-term care (LTC) riders, are typically tax-free, assuming that a physician certifies that the insured is expected to live no longer than 24 months or that they have begun suffering a chronic illness.
After Republicans took control of both the United States Congress and Presidency in the 2016 election, they passed the Tax Cuts and Jobs Act of 2017, which had important implications on the taxation of life insurance as well as life insurance planning. This is because, naturally, any changes to life insurance policy taxation - or related taxes - must necessarily change how people assess policies and integrate them into their overall financial strategy.
The big impacts were as follows:
Just recently, with the passing of the year-end omnibus spending and relief bill by Congress, there have been some additional changes to the taxation of life insurance. The bill amended the Internal Revenue Code’s Section 7702, which without getting too technical, outlines what exactly qualifies as life insurance, as discussed above.
Under previous law, life insurance companies were required to provide interest rates of at least 4% on the accumulated cash value of permanent life insurance policies. However, this 4% requirement dates back to the 1980s, when interest rates were significantly higher than the all-time lows we are experiencing now. Under the new modification, this requirement has been lowered to 2%.
This change has made selling policies much more attractive, since the high interest rate of 4% is much higher than many rates available through CDs and government bonds and other long-term investments. This will also be advantageous to individuals who can afford to put extra payments into their policy, since the lower rate will make it much more feasible for life insurance companies to allow this now that they no longer have to maintain a 4% interest rate on the cash value of new policies.
Due to the nature of life insurance policies and the financial objectives they are used to achieve, taxation and any benefits thereof are inherently intertwined with understanding and evaluating policies. The detailed and technical nature of tax codes is certainly very daunting, and truly understanding all the minutiae is something best reserved for professional tax advisors. However, this does not mean that you cannot and should not have a basic, foundational understanding of the tax implications on the various types of policies you may be considering. Having a general working knowledge of the relationship between life insurance and taxation can help you engage with and understand policies in a more meaningful way, and allow you to make better decisions that align with your overall financial goals.
At StarFort Financial, we bring each of our clients, including both individuals and businesses, custom-tailored, unique, and specific life insurance solutions. If you have any questions about life insurance options or how our innovative and unique approach to life-insurance advising takes policy options, taxation outcomes, and financial objectives into account, please don’t hesitate to reach out. We are always happy to discuss how we might be able to help you realize your long-term life insurance and financial goals.
StarFort Financial is a leading life insurance advisory firm representing high net worth clients across the United States. We tailor insurance solutions that fortify wealth within estates and businesses. We pride ourselves on our unwavering commitment to being loyal financial advocates for our clients.
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