Tax Treatment of Life Insurance

Neither Bankers Life and Casualty Company nor its agents offer tax advice. The information contained on this web site summarizes our understanding of current tax laws that relate to insurance. See the policy delivered to you for exact terms, definitions, limitations, exceptions and conditions. We recommend that you consult a qualified attorney, accountant or tax expert for advice regarding your specific situation.

Tax Treatment of Life Insurance

Life insurance policies receive favorable tax treatment under the law. Section 101 of the Internal Revenue Code provides that the proceeds of a life insurance policy maturing as a death claim, subject to the exceptions stated in the law, are not subject to income tax when paid. This tax benefit is one of many fundamental reasons for the growth of the life insurance industry.

Tax Legislation

With the passage of the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), Congress provided a mechanism to allow Universal Life - type policies to be treated as life insurance for tax purposes, thus providing the UL policies the tax benefits of IRS Section 101 treatment. TEFRA addressed only "flexible premium" life insurance and left open the need for a statutory definition of life insurance as a whole. Subsequent to TEFRA, the Deficit Reduction Act of 1984 (DEFRA) was passed. Basically, DEFRA took the TEFRA rules and modified them, providing a general set of qualifications for any contract to qualify as a life insurance policy for income tax purposes. Included were tests that effectively limited the amount of premium and required at least a minimum amount of pure risk coverage in order to qualify. Thereafter, compliance has become a matter of mathematical calculation and ongoing testing to assure policies meet the statutory definition both at issue and while they remain in force.

By providing a consistent definition of life insurance, DEFRA effectively made it clear that all qualifying life insurance policies will be taxed under the favorable rules provided by the Internal Revenue Code. Basically, that means that the death proceeds of life insurance are generally received income tax free by the beneficiary. This applies to the full death benefit, including the cash value component. This means that any interest increment included in the policy cash value and death benefit is free from federal income tax when paid at death.

The Technical and Miscellaneous Revenue Act of 1988 (TAMRA) created a new category of life insurance policy called a Modified Endowment Contract (MEC). TAMRA defines such a contract as one which fails to meet certain premium limitation tests, first on an annual and then on a cumulative basis. The TAMRA test period runs for 7 years from the time it starts, hence its common name, the "7-Pay Test".

As with TEFRA and DEFRA, compliance with TAMRA involves fairly straightforward mathematical computations performed by life insurance companies. It should be noted that death benefits of both types of policies (non-MECs and MECs) are generally paid free from income tax, including any cash value component. Policy distributions, however, are taxed differently depending on whether or not the life insurance policy is classified as a MEC.

Modified Endowment Contracts

This is any permanent policy that fails a seven pay - test described in IRS Code 7702A. Congress has determined that MECs must form a special category of life insurance and be subject to special rules of taxation. MECs are still life insurance, but Congress considers them to be a close relative to investments because of the emphasis on tax-deferred buildup of cash values. If cash values accumulate too fast in a life insurance policy, it might be considered more of an investment vehicle than protection against premature death. Therefore, MECs enjoy some but not all of the tax advantages of regular life insurance policies. The major drawback to a MEC is the 10% federal penalty for early withdrawal prior to age 59 ½ and the fact that distributions are taxed as coming from earnings first.

In the early 1980's, the introduction of Universal Life caused some confusion. Prior to TEFRA and DEFRA, there was no specific federal law definition of life insurance. Federal taxation was governed by how the states treated the contract under their various insurance laws. If the contract met the state's requirements to be a life insurance policy, then the policy would be treated as life insurance for federal tax purposes. Universal Life uses the policy's cash value build-up to supplement future income in a client's later years and makes that cash value build-up more noticeable. Thus, cash accumulation is a major centerpiece for Universal Life sales.

Life insurance can be one of the most attractive financial products someone can consider. What has been presented here is only an overview. As with any discussion of products and taxes, there are always exceptions to the general rules.