CFP

Taxation and Business Uses of Insurance - Policy Withdrawals and Death Benefits

WITHDRAWALS AND LOANS
Policy owner's may borrow money from the cash values of their policies if they wish to do so. Policy loans are more of an advance on proceeds than a true loan. The loans may be repaid at anytime, however, if not repaid by the time the insured dies then the loan balance and any accrued interest will be deducted from the policy proceeds at death. Also, the interest that is paid on the life insurance policy is deductible by the taxpayer when actually paid, however, if the interest due is added to the principal and not actually paid, then the interest is not currently deductible.

Loan values and cash surrender values are usually shown as identical amounts in the life insurance policy and are often received tax free (except MECs). Withdrawals of living benefits within the first fifteen years of a life policy are subject to LIFO (Last in first out). Withdrawals made beyond the first fifteen years are subject to FIFO (First in first out). Keep in mind that there is a higher taxable portion of a withdrawal during the first five years, rather than years six through fifteen.

Practice Question:
Molly purchased a $100,000 whole life policy with her husband (Malcolm) as the primary beneficiary. Over the course of owning the policy, Molly received $10,000 in dividends and paid gross premiums of $40,000. Molly then surrendered the policy and received a lump sum cash value of $50,000. What are the tax consequences to Molly upon receipt of the cash proceeds from the policy?

A. Molly received $50,000 tax-free
B. Molly received $30,000 tax-free, and $20,000 as ordinary income
C. Molly received $40,000 tax-free, and $10,000 as ordinary income
D. Molly must claim the full $50,000 as ordinary income

Answer: B Molly's basis in the policy is $30,000 ($40,000 in premiums paid less $10,000 in dividends received) Therefore, Molly receives $50,000- of which $30,000 is a return of basis and $20,000 will be treated as ordinary income.

DEATH BENEFITS
To understand the taxation of life insurance proceeds, keep in mind one basic principal - death benefits paid under a life insurance policy to a named beneficiary are free of federal income taxes. When proceeds are paid out on any kind of installment basis, a portion of each payment consists of principal and a portion consists of interest. The portion attributed to interest is taxable; the remaining portion of the proceeds is received tax fee to the individual.

There is one exception; when life insurance proceeds are paid under the interest only option (the insurance company holds the proceeds for a period of time and, at regular intervals, pays the beneficiary a guaranteed rate of interest on the proceeds), interest payments are treated as taxable income but the principal amount would still represent tax-free income.

Practice Question:
Daniel, husband and father of three, purchased a $500,000 variable life insurance policy on himself for income protection in the event of his sudden death. Daniel's wife (Sarah) was named as the primary beneficiary on the contract. Daniel died unexpectedly and Sarah elected to receive a $55,000 benefit annually over a 10-year period. How much of this payment is includible in Sarah's gross income each year?

A. $0
B. $2,500
C. $5,000
D. $55,000

Answer: C
$55,000 (annual benefit) x 10 years = $550,000 total payout $550,000 (total pmt) less $500,000 (face value)= $50,000 total taxable amount $50,000 divided by 10 years= $5,000 included in gross income each year


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