Life insurance can be a superb savings asset, but it does carry distinct tax issues.
All conventional saving vehicles serve the same purpose, but the unique feature of life insurance is that it assures a desired accumulation at a specific, but uncertain time; namely at the time of the insured’s death. No other savings or investment tool makes such a guarantee.
Here are 15 life insurance tax issues to anticipate in advance of filing time, from “The Tools & Techniques of Life Insurance Planning” (6th Edition).
No 15: Gift taxes
Premium payments by an owner-insured on a policy that names someone other than the insured or the insured’s estate as beneficiary generally are not considered gifts for gift tax purposes.
However, gift tax law does treat premium payments by anyone other than the policyowner as gifts and those payments may be subject to gift tax to the extent they exceed the payer’s annual exclusion ($14,000 in 2017 as indexed for inflation). Such premiums generally qualify for the annual exclusion.
See also: 15 little-known life insurance tax facts
No. 14: Beneficiary questions
Death benefits paid to someone other than the owner-insured or the owner-insured’s estate are generally not treated as gifts for gift tax purposes.
Has your client recently changed life insurance policy beneficiaries? (Photo: iStock)
No. 13: Incidents of ownership
The estate of the insured will include the proceeds of a life insurance policy for federal estate tax purposes if the insured held “incidents of ownership” at any time during the three years prior to death or if the proceeds from the policy were payable to or for the benefit of the estate of the insured.
Incidents of ownership include such things as the right to:
- Change the beneficiary;
- Take out a policy loan; or
- Surrender the policy for cash.
No. 12: Alternative Minimum Tax
Proceeds from corporate-owned life insurance policies paid to the corporation may generate an Alternative Minimum Tax (AMT). Under a worst case scenario, this tax could amount to roughly 15 percent of the total policy proceeds paid to a corporate beneficiary.
The AMT is basically an alternative tax calculation that assures a corporation pays at least a minimum amount of tax if certain “preferred” types of income that are excludable for regular tax purposes or special deductions reduce the regular income tax “too much.”
Life insurance policies that have been sold from one policyowner to another may be subject to special taxes. (Photo: iStock)
No. 11: Private sales
In general, life insurance death proceeds are not subject to federal income taxation.
However, life insurance policies that have been sold from one policyowner to another may be subject to the transfer for value rule.
Under this rule, the portion of the death proceeds in excess of the sum of the purchase price and any premiums paid after the transfer is subject to taxation as income. In other words, if an existing life insurance policy or an interest in an existing policy is transferred for any type of valuable consideration in money or money’s worth, all or a significant portion of the proceeds may lose its income-tax-free status when the insured dies.
However, certain transfers fall within a safe harbor to the rule and therefore remain exempt from income tax. Under these safe harbor exemptions, policyowners can safely transfer policies to:
- The insured;
- A partner of the insured;
- A partnership in which the insured is a partner; or
- A corporation in which the insured is a shareholder or officer, without subjecting the policy proceeds to income tax under the transfer for value rule.
There is an additional safe harbor exception for transfers where the transferee’s basis is determined in whole or in part by reference to its basis in the hands of the transferor (e.g. transfers that constitute–at least in part–gifts).
No. 10: Interest expense
Interest paid on policy loans used for investment purposes is subject to different deductibility limits. In general, the interest on all the taxpayer’s loans, including life insurance policy loans, used to finance investments is deductible each year but only to the extent it does not exceed the taxable investment income from all investments. If interest expense exceeds investment income in one year, the taxpayer carries the excess forward and may deduct the excess interest in future years when the taxpayer has adequate investment income.
Personal interest, including interest on policy loans used for personal purposes, is no longer deductible. (Photo: iStock)
No. 9: Personal interest
In general, if a policyowner uses policy loans to pay premiums on the policy or for any other personal purpose other than to finance an investment or for business use, the interest is subject to the personal interest limitations.