1. Are life insurance proceeds payable by reason of the insured’s death taxable income to the beneficiary? .
Generally, no. As a general rule, death proceeds are excludable from the beneficiary’s gross income. Death proceeds from single premium, periodic premium, or flexible premium policies are received income tax-free by the beneficiary regardless of whether the beneficiary is an individual, a corporation, a partnership, a trustee, or the insured’s estate. With some exceptions (as noted below), the exclusion generally applies regardless of who paid the premiums or who owned the policy.
Note that death proceeds from certain employer-owned life insurance contracts received by the employer as beneficiary will not be excluded from the employer’s taxable income unless certain requirements are met. Proceeds from group life insurance can qualify for the exclusion as well as proceeds from individual policies
2. If a taxpayer gives a spouse a life insurance policy, is the taxpayer entitled to a gift tax marital deduction?
Yes. An outright gift of a life insurance policy to the donor’s spouse qualifies for the gift tax marital deduction on the same basis as the gift of a bond or any other similar property. The same should hold for subsequent premiums paid on the policy by the donor. An annual exclusion may be allowed instead of the marital deduction if the recipient spouse is not a U.S. citizen.
3. Are dividends payable on a participating life insurance policy taxable income?
As a general rule, all dividends paid or credited before the maturity or surrender of a contract are tax-exempt as return of investment until an amount equal to the policyholder’s basis has been recovered. More specifically, when aggregate dividends plus all other amounts that have been received tax-free under the contract exceed aggregate gross premiums, the excess is taxable income. It is immaterial whether dividends are taken in cash, applied against current premiums, used to purchase paid-up additions, or left with the insurance company to accumulate interest.
Thus, accumulated dividends are not taxable either currently or when withdrawn (but the interest on accumulated dividends is taxable) until aggregate dividends plus all other amounts that have been received tax-free under the contract exceed aggregate gross premiums. At that point, the excess is taxable income.
4. What are the tax results when life insurance or endowment dividends are used to purchase paid-up insurance additions?
Normally, no tax liability will arise at any time when life insurance or endowment dividends are used to purchase paid-up insurance additions. Dividends not in excess of investment in the contract are not taxable income, the annual increase in the cash values of the paid-up additions is not taxed to the policyholder, and death proceeds are tax-free. In effect, dividends reduce the cost basis of the original amount of insurance and constitute the cost of the paid-up additions. Consequently, upon maturity, sale, or surrender during an insured’s lifetime, gross premiums, including the cost of paid-up additions, are used as the cost of the insurance in computing gain upon the entire amount of proceeds, including proceeds from the additions.
5. If accumulated or post-mortem life insurance dividends are received by a deceased insured’s beneficiary, are they taxable income to the beneficiary?
No. Accumulated dividends are exempt as property received by inheritance. Terminal and post-mortem dividends are exempt as amounts received under a life insurance contract and paid by reason of the death of the insured. Moreover, it appears that accumulated interest, if constructively received by a policyholder in a prior year, is not taxable to a beneficiary even though the policyholder neglected to report the interest.
6. What is the income tax treatment of an amount received from a viatical settlement provider?
If any portion of a death benefit under a life insurance contract on the life of a terminally or chronically ill insured is sold or assigned to a viatical settlement provider, the amount paid for the sale or assignment will be treated as an amount paid under the life insurance contract by reason of the insured’s death. In other words, such an amount will not be includable in income.
7. Are there any exceptions to the general rule that viatical settlements are not included as taxable income?
There is one exception to this general rule of non-includability for viatical settlements. The rules outlined above do not apply to any amount paid to any taxpayer other than the insured if the taxpayer has an insurable interest in the life of the insured because the insured is a director, officer or employee of the taxpayer or if the insured is financially interested in any trade or business of the taxpayer.
8. Can a taxpayer deduct interest paid on a loan to purchase or carry a life insurance, endowment, or annuity contract?
Interest paid or accrued on indebtedness incurred to purchase or continue in effect a single premium life insurance, endowment, or annuity contract purchased after March 1, 1954, is not deductible. For this purpose, a single premium contract is defined as one on which substantially all the premiums are paid within four years from the date of purchase, or on which an amount is deposited with the insurer for payment of a substantial number of future premiums. When a single premium annuity is used as collateral to either obtain or continue a mortgage, the IRS has found that IRC Section 264(a)(2) disallows the allocable amount of mortgage interest to the extent that the mortgage is collateralized by the annuity.
9. What are the tax consequences of leaving life insurance cash surrender values or endowment maturity proceeds with the insurer under the interest-only option?
The interest is fully taxable to the payee as it is received or credited. Under some circumstances, election of the interest option will postpone tax on the proceeds. If the option is elected before maturity or surrender without reservation of the right to withdraw the proceeds, the proceeds are not constructively received in the year of maturity or surrender.
But if the right of withdrawal is retained, the IRS apparently considers the proceeds as constructively received when they first become withdrawable. (It can be argued, however, that the proceeds are not constructively received when the policyholder has a contractual right to change to another option.) If the option is elected on or after the maturity or surrender date, the proceeds are constructively received in the year of maturity or surrender.
10. If life insurance proceeds are payable to a religious, charitable or educational organization, is their value taxable in the insured’s gross estate?
Generally, no. If the insured has any incident of ownership in the policy at the time of death, the proceeds are includable in the insured’s gross estate, but a charitable deduction is allowable for their full value. If, however, the law in the state of the donor’s domicile does not recognize that a charity has an insurable interest in the life of the donor, complications may arise. In some states, a charity may not have an insurable interest with respect to a newly issued insurance policy given to the charity or for a policy applied for and issued to the charity as owner and beneficiary. If the charity does not have an insurable interest and the insurer or the insured’s estate raises the question of lack of an insurable interest, the insured’s estate may be able to recover the proceeds (or the premiums paid).