In general, when considering the income tax treatment of insurance, topics such as the tax-deferred buildup of cash value, the taxation of withdrawals, proceeds, loans, and dividends should be considered. The tax rules applicable to an insurance policy depend on whether the policy is one of life insurance, health insurance, long-term care insurance, disability insurance, property/casualty/liability insurance, or business insurance.
The cash value increase in an insurance policy resulting from investment income is not taxable income to the policy holder as long as the policy remains in force, even if the policy terminates in a death claim. Thus, the buildup (increase) of the cash value represents tax-deferred income.
For federal income tax purposes, an insurance contract cannot be considered a life insurance contract (and thus qualify for favorable tax treatment) unless it is a life insurance contract under applicable state law and meets one of two tests: the cash value accumulation test or the guideline premium and cash value corridor test.
The income tax treatment of a life insurance policy depends on a number of factors, including whether the policy holder or beneficiary has received a lifetime distribution, death proceeds, or dividends. Generally, lifetime distributions (other than loans) from life insurance policies are treated as first coming out of your basis or investment in the contract. Only lifetime distributions in excess of your basis are taxable.
A lifetime distribution is any payment from the cash value of a life insurance policy during the lifetime of the insured, as opposed to the payment of the proceeds following the death of the insured. Special rules apply to loans. Partial surrenders and full surrenders are the two major types of lifetime distributions.
With a loan, the policyowner borrows money from the insurance company, using the cash value of his or her policy as collateral to secure the loan. The amount of the loan balance reduces both the cash surrender value of the policy and the death proceeds until the loan is repaid. No portion of the proceeds of policy loans are included in the income of the policy holder, because they are not treated as “distributions.” Taxable income is not recognized as long as your policy remains in force. However, if your policy lapses or you surrender the policy, you’ll have to treat any outstanding loan balance as a distribution and recognize any unrealized gain as taxable income.
Assume you have a life insurance policy as follows: cash value equals $15,000, owner’s basis equals $14,000, and unrealized gain equals $1,000. If you borrow $15,000 from your life insurance policy, your unrealized gain of $1,000 will not be included in your income at present. At your death, your insurance company will subtract any outstanding loan balance (plus interest) from the death proceeds and pay the remainder, free from income tax, to your beneficiary. (The issue date of the policy doesn’t matter for loans.) If your policy lapses before your death, then the outstanding loan balance will be treated as a lifetime distribution.
In many cases, you may choose simply to withdraw and keep all or part of the cash value buildup in your policy. This is known as a partial surrender, which reduces the cash surrender value of the policy and the death benefit amounts. Any distribution will be treated as coming first from your basis in the policy, and only amounts received in excess of your basis will be treated as taxable income.
A full surrender occurs when you discontinue your policy. Typically, the insurance company sends you a check for the net cash surrender value at such a time. In the case of a full surrender, you must include in income the difference (if any) between the cash surrender value of the policy and your basis.
Generally, amounts you receive under a life insurance contract paid by reason of the death of the insured are not included in your gross income; the proceeds are tax free. Amounts payable on the death of the insured are excluded, whether these amounts represent return of premiums paid, the increased value of the policy due to investments, or the death benefit feature. It is immaterial whether the life insurance proceeds are received in a single sum or otherwise. However, any interest paid along with the life insurance proceeds is usually taxable.
It’s also important to be aware of the estate and gift tax treatment of life insurance death proceeds. In general, the proceeds of a policy are included in the estate of the insured if: (1) the proceeds were payable to or for the benefit of the estate of the insured, (2) the policy was transferred by the decedent for less than adequate consideration within three years before his or her death, or (3) the insured held any incidents of ownership at the time of death, such as the right to change the beneficiary. Further, if you make a gift of a life insurance policy during your lifetime, the fair market value of the policy at the time of the gift may be subject to federal gift tax.
An insurance dividend is the amount of your premium that is paid back to you if your insurance company achieves a lower mortality cost on policyholders than it expected. The dividend is not treated as taxable income to you unless it exceeds the amount of your basis in the contract. It doesn’t matter whether the dividends are received in cash or left with the insurance company for some purpose. If you leave this dividend on deposit with your insurance company and it earns interest, however, the interest that accrues should be included as taxable interest income as it accrues.
The premiums you pay for life insurance coverage are generally not deductible.
A modified endowment contract (MEC) is a special class of life insurance contract. Special income tax rules apply to MECs. Generally speaking, loans and partial surrenders from MECs result in immediate taxation of policy gains, because lifetime distributions with respect to MECs are treated as coming from policy earnings before basis. In addition, withdrawals from and borrowings against a MEC before the policyholder reaches age 59½ may be subject to a 10 percent penalty. (However, there are certain exceptions to this penalty tax that apply if the policyholder is disabled or the distribution is part of a series of substantially equal periodic payments.)
Tax rules differ, depending on whether you’re discussing insurance benefits or insurance premiums.
In general, health insurance reimbursement of your medical expenses is not taxable to you. This is true whether you pay the insurance premiums yourself (in whole or in part) or whether your employer pays the premiums for you. There are some important provisos, however.
If you pay for health insurance premiums yourself, you may be able to deduct the premiums as unreimbursed medical expenses (if you qualify). Special rules apply to self-employed persons. If your employer pays the premiums for your health insurance, you generally do not have to include such premiums in your income.
You can deduct premiums paid for a qualified long-term care insurance contract. Contracts issued on or after January 1, 1997, however, will be treated as qualified long-term care insurance contracts only if they meet certain federal standards. Long-term care insurance premiums are deductible as medical expenses only if they meet the 7.5 percent of the AGI floor.
Benefits you receive with respect to a tax-qualified long-term care insurance contract are not taxable to you as income; rather, they are treated as excludable benefits received for personal injury and sickness. It is possible, however, for benefits received with respect to a nonqualified long-term care insurance contract to be taxable to you as income.
Starting in 2013, the 7.5 percent floor on itemized deductions for medical expenses increases to 10 percent. However, taxpayers age 65 and over will remain subject to the 7.5 percent floor until 2017.
Disability insurance policies typically pay a percentage of your income if you become sick or disabled and unable to work at your occupation. If you pay the disability premiums, the benefits are not taxable. If disability insurance is provided through your employer, the benefits may be taxable if your employer paid the premiums and the premiums were not considered taxable income for you. However, the disability benefits will not be taxable (regardless of who paid the premiums) if they represent merely a reimbursement of your medical expenses, permanent loss or loss of use of part of the body, or disfigurement. In general, you cannot deduct the premiums.
Tax rules regarding property, casualty, and liability insurance may vary, depending on whether you’re an individual or a business owner. (A casualty is the damage, destruction, or loss of property resulting from an identifiable event that is sudden, unexpected, or unusual.) If your property is covered by insurance, you should file a timely claim for reimbursement of your loss. In general, a reimbursement from your insurer is not taxable. Any unreimbursed loss may be deductible if you meet all applicable conditions. And if the amount of your reimbursement exceeds the loss that you deducted, you may have to report taxable income.
Businesses often use several different types of insurance policies, so the tax treatment will vary, depending on the type of policy. Life insurance in the form of group insurance, key employee coverage, split dollar, or corporate-owned can be used as an employee benefit and/or to benefit the business. In addition, property, casualty, and liability insurance policies are used to guard against disasters and lawsuits. Furthermore, insurance can be used to fund retirement plans and buy-sell agreements. As a business owner, you’ll be concerned both with the deductibility of premiums and the taxation of proceeds.