8.2 Taxation of Life Insurance Benefits

• Library: A Lawyer's Guide to Estate Planning: Fundamentals for the Legal Practitioner (ABA) (2018 Ed.)

8.2 Taxation of Life Insurance Benefits

8.21 Benefits Received during Lifetime

If the owner of a life insurance policy elects to receive the cash benefits that have built up in the policy during lifetime, income tax will be owed. The difference between the cost of the policy to the owner and the amount received is taxed as ordinary income.³ The owner's cost is simply the total gross premiums paid.⁴ Any premiums paid for accidental death benefits or for the option of waiver of premiums in the event of disability must be excluded from the cost of the policy because this portion of the premiums does not contribute to the cash value of the policy. Any policy dividends that were received in cash or used to reduce premium payments must also be excluded from the gross premiums.⁵

If the owner of the policy elects to receive policy benefits other than as a lump sum, the benefits are taxed under the annuity rules of Section 72 of the Internal Revenue Code. These rules simply tax the portion of each payment that represents gain in excess of the cost paid by the owner for the annuity. To determine the amount of the payment that represents the owner's cost and is excluded from ordinary income, the following formula can be used:

Amount Excluded = Annual Annuity Payment x [Owner's Total Cost / Annual Annuity Payment x Owner's Life Expectancy per IRS Tables]⁶

8.22 Benefits Received following Death

The life insurance proceeds received by a beneficiary of a decedent's life insurance policy are not subject to income tax.⁷ In the event the beneficiary elects a settlement option other than a lump-sum payment, the interest portion of each payment is subject to income tax, but the principal continues to be income tax free.⁸

Caution: The "transfer for value" rule creates a potentially troublesome problem. Basically, in those rare situations in which, before death, the insured transfers for value (i.e., sells) a life insurance policy on his life, an income tax will be owed by the purchaser on the subsequent receipt of the insurance proceeds at the insured's death. The taxable amount is the difference between the life insurance proceeds received and the amount paid for the policy plus the premiums paid by the purchaser.⁹

Planning Pointer 1

A transfer of a policy between family members should be handled strictly as a gift to avoid the "transfer for value" problem. No consideration should be involved.

A transfer of the insured's own life insurance policy to the insured, his or her...