10 / What are the rules for taxing living proceeds received under life insurance policies and endowment contracts?

Generally speaking, living proceeds are proceeds received during an insured’s lifetime. The rules in IRC Section 72 govern the income taxation of amounts received as living proceeds from life insurance policies and endowment contracts. IRC Section 72 also covers the tax treatment of policy dividends and forms of premium returns.

Payments to which IRC Section 72 applies are of three classes: (1) “amounts not received as an annuity,” (2) payments of interest only, and (3) “amounts received as annuities.”

When living proceeds are held by an insurer under an agreement to pay interest, the interest payments are taxable in full ( Q 21).¹ Periodic payments on a principal amount that will be returned intact on demand are interest payments.²

All amounts taxable under IRC Section 72 other than annuities and payments of interest are classed as amounts not received as an annuity. These include policy dividends, lump-sum cash settlements of cash surrender values and endowment maturity proceeds, and cash withdrawals and amounts received on partial surrender.³

The income tax treatment of life insurance death proceeds is governed by IRC Section 101, not by IRC Section 72. Consequently, the annuity rules in IRC Section 72 do not apply to life income or other installment payments under optional settlements of death proceeds. However, the rules for taxing such payments are similar to IRC Section 72 annuity rules ( Q 63 to Q 79).

Living proceeds received under life insurance contracts and endowment policies are taxed according to the same rules, whether they are single premium or periodic premium policies. Except for interest and annuity settlements, they are taxed under the “cost recovery rule” no matter when the contract was entered into or when premiums were paid. In other words, such amounts are included in gross income only to the extent they exceed the investment in the contract (as reduced by any prior excludable distributions under the contract). Living proceeds or distributions received from a life insurance policy that has failed the seven pay test of IRC Section 7702A(b) and, therefore, is classified as a modified endowment contract are taxed under different rules.