Last updated: January 14th, 2023
Reviewed by
Grant Desselle
Licensed Insurance Agent
Table of Contents
Your beneficiary receives the death benefit if you die when insured. The IRS notes that death benefits from a life insurance contract are generally tax-free for the beneficiary. Meaning, your beneficiary will not need to pay tax on the death benefit they receive. However, if the death benefit comes in installments versus a lump-sum, any interest each payout gains is taxable.
The cost basis of a permanent life insurance policy is generally the sum of all the premiums you’ve paid into the policy. The cash value is the total premiums plus the investment gains, minus various insurance charges. The investment gains generated within the policy are tax-deferred. Gains are only taxable when they come out of the policy through withdrawals or surrenders.
Examples of distributions from a life insurance policy include full surrender, partial withdrawals, policy loans, and policyholder dividends. To understand the taxation of distributions from your life insurance policy, you need to have a general understanding of the Internal Revenue Code Section 7702A. Life insurance receives a more favorable tax treatment than annuities. Section 7702A is to restrict the preferential tax treatment on contracts with excess premium payments in earlier years of the policy. It defines a class of life insurance contracts known as a modified endowment contract (MEC). A MEC policy is a life insurance policy qualified under Section 7702 but fails the requirements under Section 7702A.
Brian Greenberg, CEO of Insurancy, illustrates one of these situations with an easy to understand example in the following video:
Life insurance is one of the best investments you can have to ensure your loved ones receive insurance protection should the unfortunate occur to you.
There are two main types of life insurance policies:
Below we will discuss the intricacies of taxation related to cash value life insurance policies and answer any questions you may have.
While life insurance benefits normally aren’t taxable, there are four main caveats. They are:
The benefits from your life insurance policy are only tax-free if you pay your premiums with after-tax funds, versus deducting them.
Consider someone who has a $1 million life insurance policy. If they deduct their premiums from their tax returns, then their beneficiaries will not receive the full death benefit. Instead, they would be responsible for paying 30% of the benefits in taxes. In this case, that measures up to nearly $300,000 in taxes. Here, it should be clear that paying premiums with after-tax funds will result in savings for your beneficiaries.
To understand the taxation of life insurance policies, you first need to have a general understanding of the definition of life insurance, as prescribed by Internal Revenue Code. Life insurance policies are a combination of savings/investment and pure insurance, which provides financial protection from unfortunate events such as death. Internal Revenue Code Section 7702 exists to regulate the relationship between these two elements. It exists to define what the federal government considers as a life insurance policy, which receives favorable tax treatment.
Both requirements exist to ensure that the policy has enough insurance protection in comparison to the cash value. If the policy doesn’t meet either requirement, it becomes an investment vehicle and isn’t eligible for favorable tax treatments. On the upside, insurers design most life insurance policies on the market today so they’re in compliance with 7702. Therefore, as long as you fund the policy with the suggested premiums amounts, your policy will be eligible for favorable tax treatment.
Most policies also comply with either the CVAT or GPT tests. You, as the policyholder, can choose either test. The test selected can have drastic impacts on your premiums, policy values, and death benefit. An insurance agent will be able to walk you through which test to choose based on the illustrations and your personal preferences. Once you select the test, you cannot switch it throughout the policy’s lifespan.
Modified endowment contract (MEC) policies are typically life insurance policies that build a large amount of cash value in a short period of time. Under section 7702A, the IRS uses the 7-pay test to determine whether a life insurance policy is MEC. The test sets the limits for the cumulative premiums you can pay into a policy for the first 7 years. If the cumulative premiums paid exceed the limits anytime during the first 7 years, the policy is classified as MEC. For MEC policies, pre-death distributions (e.g. policy loans, partial withdrawals, and policyholder dividends) are subject to more restrictive tax rules than distributions from life insurance policies that are non-MECs.
For example, if you own an indexed universal life policy with MEC limit being $10,000 for the first 7 years of the policy. This means you can pay up to $10,000 every year without pushing your policy into MEC status. However, if in year 5 you paid $12,000, this will cause the cumulative premium to exceed MEC premium limit, leading to your
policy to be classified as MEC. You also cannot change the MEC status later on if you pay fewer premiums in future years. When this excess premium payment happens, most insurance companies will notify the policyholder and provide a premium refund within a certain time period (e.g. 60 days) to avoid the policy from being classified as MEC.
The following chart summarizes the different requirements used to classify a contract as non-MEC life insurance, MEC life insurance, or investment vehicle, as prescribed by Section 7702 and 7702A.
If you do not intend to take any distributions throughout your policy years, there will be no adverse tax implications to your beneficiaries if your life insurance policy is MEC or single premium whole life insurance policy. MECs are still a life insurance policy. Meaning, they still offer tax-free death benefits and tax-deferred policy cash value accumulation. One difference between MEC and non-MEC is the tax treatment for policy distributions.
However, if you do plan to take distributions throughout your lifetime, they will be taxed as “income first.” Also commonly called “last-in, first-out” (LIFO). This means that any policy distributions come from the cash value investment gains first, which are taxable. No distributions are tax-free until you drain the policy gains. For example, if your policy basis is $10,000, and the total cash value is $12,000, which means your policy gain is $2,000. Any withdrawals you take from the policy’s cash value under $2,000 will be taxable. If you take $3,000 withdrawal, $2,000 will be taxable and $1,000 will be tax-free. Furthermore, with MEC policies, you must pay a 10% penalty for early withdrawal, if you take distributions before age of 59.5.
In 1946, the 8th District U.S. Circuit Court of Appeals ruled in the case of Goodman v. Commissioner of the Internal Revenue Service to allow for the IRS to tax life insurance payouts in the event that the owner, the insured, and the beneficiary were all different people or organizations. Based on this ruling, the premiums paid by the policy owner for coverage of separate individuals that provided a financial benefit of yet another party can be considered a gift and therefore subject to applicable tax laws.
In order to avoid incurring tax penalties on life insurance payouts, there should be no more than two parties involved in a life insurance policy.
Most times, insurers structure their life insurance policies as non-MEC life insurance. Meaning, it’s in compliance with both 7702 and 7702A. These policies receive the most preferable tax treatment. The only difference between MEC and non-MEC is tax treatment for policy distributions. MEC policies are taxed under the LIFO approach, while non-MEC policies are taxed under a FIFO basis (first in first out). Meaning, any withdrawal you take will be tax-free up to basis. Once you drain the policy basis, any further distributions will then be taxable.
For example, if your policy basis is $10,000 and the total cash value is $12,000, your policy gain is $2,000. Any withdrawals you take from the policy’s cash value under $10,000 will be tax-free.
In summary, for a non-MEC policy, any distributions that are less than the premiums you’ve paid will be tax-free. This means:
As discussed in previous sections, there are numerous tax benefits of a life insurance policy. You can leverage them to provide yourself with a tax-free income supplement. You can withdraw cash value, take policy loans, and receive dividends all tax-free up to the basis of your policy, while at the same time the investment gains within the policy are tax-deferred.
Many pre-retirees and retirees are concerned about the risks of chronic and terminal illnesses. With life insurance, some policies have riders attached that can provide tax-free benefits when you have qualified chronic or terminal illness. These are similar to LTC (long term care) insurance, except that they are part of a life insurance policy. And unlike LTC insurance, which is “use it or lose it,” if you are healthy and don’t use the chronic or terminal illness benefits, these benefits add to your death benefits payout. An accelerated death benefit is a kind of living benefit commonly attached to a permanent life insurance policy. The benefits are then provided tax-free to the insured to supplement any costs incurred during a chronic and terminal illness.
When you withdraw assets from your 401(k) or IRA, that income is subject to taxation at your income tax rate. You may believe that your tax rate will be much lower in retirement than it is during your working years, but this isn’t always true. Many couples face the risk of incurring high taxes on retirement income, depleting financial capital sooner than expected. In fact, a significant portion of 401(k) and IRA savings will be taxed at a marginal tax rate that can approach and even exceed 50% if withdrawals are not structured appropriately.
The reason many retirees will pay high marginal tax rates on their IRA withdrawals is that these withdrawals will force the taxation of Social Security income, which would otherwise be received tax-free. For a married couple, Social Security income is tax-free if their total income is below $32,000; up to 85% of the social security income is taxable if total income is higher than $44,000. This means $1 of IRA withdrawals results in $1.85 of taxable income, which can create very high marginal tax rates on IRA withdrawals.
For example, if a married couple is in the 25% tax bracket, they will be in 46.25% marginal tax rate for one additional dollar of IRA income: ($1 (IRA income) + $1 (Social Security income) x .85) x .25 (tax rate). Some refer to this phenomenon as the “Tax Torpedo.” State taxes on the IRA withdrawal can then push the marginal tax rate up over 50%. The tax advantages of your permanent life insurance policy will reduce the impact of the tax torpedo on Social Security income:
While many types of income are taxable, tax-free life insurance withdrawals and loans are not. Once you withdraw Social Security income, you can avoid the tax torpedo by withdrawing income from a policy’s cash value. For example, a couple may wish to take some income in the form of IRA withdrawals along with Social Security. Then they can switch over to life insurance withdrawals when they approach the taxable threshold.
The tax torpedo penalizes widowed spouses, as Social Security tax thresholds and income tax brackets are lower for single individuals. One way to lessen the tax burden is to leave the widowed spouse a higher Social Security survivor benefit (by delaying claiming the benefit) along with a life insurance death benefit, rather than a larger IRA balance and a lower Social Security survivor benefit. A tax-free life insurance death benefit can generate income that, when coupled with a higher Social Security survivor benefit, can result in lower taxes than the alternative approach.
In summary, your life insurance policy receives favorable tax treatment versus investment vehicles such as mutual fund investments or annuities.
The death benefit your beneficiary receives is generally tax-free. The cash value that accumulates within the policy is tax-deferred and not taxable as current income. Policy distributions such as partial withdrawals, surrenders, loans, and dividends aren’t taxable up to the total premiums.
You can leverage the tax benefits for a life insurance policy in many ways:
Understanding whether your life insurance policy is taxable and its tax benefits can help you better utilize your insurance policy to provide not only financial protection for your loved ones but also benefits for yourself throughout your lifetime.
Brian is the founder and CEO of Insurist and carries Life, Health, and Property & Casualty licenses in all 50 U.S. states. Since 2013, Brian has been a member of Million Dollar Round Table, a designation for the top 1% of financial advisors worldwide. Brian has been featured in Yahoo! Finance, Money.com, Entrepreneur.com, Life Happens, Forbes, MSN, and Good Financial Cents. Brian’s goal is to show customers the best products, the quickest answers to their questions, and provide expert advice.
Grant's past experience includes work as a licensed sales agent for Hagerty Insurance. He has reviewed thousands of existing auto policies across the nation and issued hundreds of new ones on everything ranging from classic cars undergoing restoration to modern exotics and motorcycles.
