Life insurance policy is a useful tool through which individuals and families with limited resources may achieve multiple financial goals. With a permanent life insurance policy, one is capable of securing his or her family’s future in case of accidental death or incapacitation. Specifically, life insurance proceeds can go a long way in providing for the family’s daily expenses, paying off mortgages, setting up a college fund, and, most importantly, supplementing one’s retirement income. In case of death, these proceeds can go into paying off the debts owed by the deceased or financing the funeral expenses.
This research paper provides background information on the taxation of life insurance proceeds by exploring current tax laws applicable in different states across the United States. From this background, the paper provides reasonable arguments against taxing life insurance proceeds considering that such proceeds serve important purposes in the society. In this context, the paper explores various ways through which individuals and families can avoid taxation on life insurance proceeds. In conclusion, the paper emphasizes that life insurance proceeds should not be taxed since they act as a form of compensation for death of principal financial providers in many households.
Should Life Insurance Proceeds Be Taxed?
Life insurance is a type of insurance in which monetary proceeds must be paid to beneficiaries when the insured/policy holder dies. Essentially, through a life insurance policy, the insured and the insurer are tied by a contract which states that the insurance company must pay a specified amount of money to a named beneficiary upon the insured’s death. As a result, life insurance serves a variety of purposes. For instance, individuals with life insurance ensure that their family members are financially secure when they die. Moreover, the proceeds from the insurance cover can go to helping the surviving family members besides catering for hospital/funeral expenses, maintaining family businesses, and even paying off debts owed by the deceased policy holder. Generally, life insurance can be purchased by individuals or provided by employers and the government through group life insurance plans. Furthermore, under the group insurance cover, individual employees can obtain additional covers at reduced rates (Hunt & Hunt, 2004).
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Currently, there are many life insurance categories and products in the market including term life insurance, whole life insurance, universal life insurance, and variable life insurance. Whichever type of life insurance held by the insured, proceeds from the insurance cover must be paid to the beneficiary upon the policy holder’s death. Under the current taxation laws in the United States, some aspects of the life insurance proceeds are taxable. This essay examines the current forms of taxation on the life insurance proceeds with the aim of providing well-supported arguments against the taxation of such proceeds and benefits.
Taxation of Life Insurance Proceeds
Generally, the law states that if the holder of a life insurance policy decides to receive cash proceeds that have accrued during the life of the policy, the insured is supposed to pay income tax. Here, the owner of the policy should pay income tax for the difference between the cash value of the policy and the amount of money received in form of life insurance proceeds. Therefore, the policy holder’s cost equals to the total amount of premiums paid. However, the premiums paid upon the accidental death of the insured or for the purpose of a waiver of premiums in case of disabilities are not included in the taxable benefits considering that these premiums do not add to the cash value of the insurance policy. Further, the gross premiums do not include policy dividends payable in cash or used to make premium payments (Hunt & Hunt, 2004).
On the other hand, if the owner of a life insurance policy decides to receive the policy proceeds, but not as a lump sum amount, the policy benefits are eligible for taxation as provided for under the annuity rules (Section 72 of the Internal Revenue Code). Under the annuity rules, each payment of policy benefits that exceeds the amount paid by the policy owner for the annuity must be taxed (Hunt & Hunt, 2004).
At the same time, the life insurance benefits received following the death of the insured are not subject to income taxation. However, if the beneficiary of decedent’s life insurance proceeds decides to receive the benefits through other means rather than as a lump sum amount, the interest accrued for each portion of the payments is taxed as income tax. In this case, the principal amount of the policy continues to be nontaxable. Yet, it is important to note that life insurance proceeds are subject to income tax in case before his/her death the insured decides to transfer the policy for value. Here, the purchaser of a life insurance policy will owe income tax on the proceeds received upon the insured’s death. The amount taxed in this case equals to the difference between the cost of life insurance proceeds paid to the purchaser and the amount paid for the insurance policy including the subsequent premiums paid by the new owner.
Further, if a transfer of the insurance policy is made to the insured’s partner, to a partnership involving the insured as one of the partners, or a corporation in which the insured is included as a major shareholder/staff/employee/officer, the “transfer for value” rule on the proceeds does not apply. This exception affecting the insured’s partners, partnerships, and corporations is very beneficial because sometimes insurance policy transfers serve genuine business purposes, especially in the buy-sell agreements. However, caution should be observed when making policy transfers between corporate stakeholders for the purpose of funding another cross-purchase agreement because such an arrangement is subject to the “transfer for value” rule.
Therefore, if a transfer occurs between corporate stakeholders, the life insurance proceeds received by the transferee after the death of one of the stakeholders will be taxed as ordinary income (Hunt & Hunt, 2004; Tannahill, 2012). Similarly, when corporations make insurance policy transfers to their own stakeholders, the “transfer for value” rule applies to the policy proceeds. More specifically, when a corporation exchanges a redemption agreement for the stakeholders’ cross-purchase agreement, the policy transfer is not excluded from the “transfer for value” rule, which requires that the proceeds from the policy must be taxed as ordinary income.
Additionally, life insurance benefits are not excluded from the federal estate tax. Basically, the law states that the life insurance proceeds can be included in the federal estate tax if the proceeds are paid to the insured’s estate or if the deceased was the owner of the insurance policy. Furthermore, the proceeds are included in the estate tax if the owner of the policy was not the actual owner, but he or she retained some aspects of ownership including, for example, the right to change the names of beneficiaries. Moreover, life insurance proceeds can be subject to the federal estate tax in case the insured died within the first three years after making a transfer to another person. However, if the insured transfers the policy to his or her family member and survives the first three years after the transfer, the life insurance proceeds will be received by the beneficiary without being subject to the federal estate tax (Brenner, 1993; Hunt & Hunt, 2004).
Reasons against Taxation of Life Insurance Proceeds
From the foregoing discussions, it is evident that life insurance proceeds can be exempted from income tax, but they are always susceptible to the federal estate tax. If to assume that the life insurance plan does not fall under the “transfer for value” rule, the Internal Revenue Service (IRS) is still entitled to more than 55 percent of the life insurance proceeds through the federal income taxes (McDevitt, 1993). This is a very large amount of money taxed from a life insurance plan that is meant to serve a variety of social and economic purposes long after the family breadwinner is dead. Here, it is important to note that a permanent life insurance plan helps individuals and families to attain a variety of goals with minimal resources. In most cases, individuals and families use life insurance as a means of supplementing their retirement income and other government-sponsored social services (Tannahill, 2012). Therefore, having enough resources for retirement is an important financial goal for most individuals and families, and this goal may not be achieved if life insurance proceeds are subject to state and federal taxations.
Experts posit that a well-designed life insurance plan, be it whole life, universal life, variable universal life, or indexed universal life insurance can go a long way in helping individuals and families to achieve both life insurance coverage and retirement goals. More specifically, studies have shown that a good life insurance plan provides security and protection against any unanticipated financial consequences that may arise upon the insured’s death. Thus, if the insured family’s breadwinner dies accidentally, the surviving family members are entitled to receiving the life insurance proceeds. While these proceeds cannot be compared to what the deceased would have provided for the family if he or she was alive, they can serve a variety of purposes including meeting the family’s daily expenses, paying off mortgages, setting up a college fund, and settling debts among other pressing needs.
On the other hand, a life insurance policy enables the owner to set aside a substantial amount of money to cater for retirement and other important purposes. For instance, upon paying sufficient premiums on the life insurance policy, the owner is assured of a significant amount of money in the form of the gross premiums plus the accrued interest on the paid premiums. These funds can be received through policy withdrawals or in the form of a loan and used for other important purposes including supporting the family daily expenses, settling bills, and paying off mortgages. Therefore, despite the fact that these life insurance benefits are not subject to income tax when the policy is designed appropriately, they should not be subject to any form of taxation including the federal estate tax either because they serve very important purposes in the society, especially in the case of low- and middle-market households (Tannahill, 2012).
Along the same perspective, life insurance proceeds should not be taxed because it is logical to impose tax on the assets owned by the insured at the time of his or her death, but not applying tax to benefits that are payable as a result of the insured’s death. The logic here is that the net amount in the life insurance contract should be viewed as a form of compensation for the loss of the family’s breadwinner (Solomon, 1963). Furthermore, numerous problems arise in the subjection of life insurance proceeds to state and federal taxations. In most cases, it is difficult to determine whether the life insurance benefits fall under the category of testamentary transfers or they are just dispositions that serve the testamentary function (Solomon, 1963). Furthermore, it is sometimes difficult to decide whether the policy is an actual transfer from the insured to the named beneficiaries or it is just a mere contract between the insured and the insurer, which means that the rights of the beneficiaries become vested at the time the policy is issued as opposed to when the insured dies. Thus, taxation of life insurance proceeds raises a number of problems, particularly when all the proceeds payable to the decedent’s estate are subject to death taxation.
Again, it is imperative to emphasize that life insurance proceeds payable to named third-party beneficiaries should be exempted from any form of taxation for a number of reasons. First and foremost, the life insurance proceeds are not passed on to the named beneficiaries by will or rather there is no state or federal law providing for the passage of such proceeds to the beneficiaries. Secondly, the rights of the named beneficiaries on the proceeds become vested upon designation. Thirdly, experts have observed that the life insurance contract is not meant for the insured, but it is rather set up to benefit third party beneficiaries who would otherwise suffer upon the insured’s death. Lastly, it is only logical for the government to extend favorable consideration to third party beneficiaries who are entirely dependent on the life insurance proceeds for their economic existence upon the death of the only financial provider (Tannahill, 2012; Solomon, 1963). Therefore, a special exemption on taxation of life insurance proceeds should be considered on the basis of the foregoing reasons.
However, those opposed to the proposition that life insurance proceeds should be excluded from taxation may argue that the named beneficiaries do not have any rights considering that the life insurance proceeds are payable upon the insured’s death and not before. Moreover, it is safe to argue that many rich people can exploit the special exemption applied on the life insurance proceeds in order to transfer large amounts of cash to life insurance for the purpose of avoiding taxation.
Furthermore, it is arguable that tax exemption on life insurance proceeds discriminates against other taxpayers who cannot afford life insurance (Solomon, 1963). Nonetheless, it is imperative to note that life insurance is a contract between the insured and the insure, which can possess some element of indemnity. Therefore, it is important that life insurance proceeds be exempted from taxation because such benefits act as some form of compensation for the death of the insured. Furthermore, it is important for the government agencies to draw a distinction between the life insurance contracts that serve the indemnification function and other annuity contracts which can attract different forms of taxation.
The hassle of having to pay income and estate taxes on life insurance proceeds can be bypassed through an appropriately designed life insurance plan. Generally, a well designed life insurance plan should take into consideration a variety of important tax rules. First and foremost, Section 72(e) of the taxation laws indicates that the cash value of the life insurance policy is excluded from income tax as it adds up or when it is received by the owner in the form of loans or withdrawals. Secondly, the laws state that life insurance proceeds should not be subject to the federal income tax except for when one violates the “transfer for value” rule as outlined in Section 101(a) (2) or when Section 101(j), which caters for the employer-owned life insurance policy, is violated. Therefore, unless one violates either of the above-mentioned provisions, the named beneficiaries are entitled to receiving the life insurance proceeds without income tax upon the insured’s death. Thirdly, it is imperative to note that in case the insured has any form of ownership in the policy upon his or her death, the life insurance proceeds are subject to the federal estate tax. For example, when the insured possesses the right to change the names of the beneficiaries or obtains a loan on the cash value, it is determined that the insured has some aspects of ownership in the policy. Therefore, in case the insured retains some rights on the policy, and thus, access to the cash value, the life insurance proceeds are included in the estate tax. Lastly, if the insurance policy is terminated before the owner settles a policy loan, it follows that the cash value is subject to income tax, particularly when the amount of the remaining cash value and the loan is more than the gross premiums (Tannahill, 2012).
As a result, it is very important to take the foregoing tax rules into consideration before purchasing a life insurance policy for the purpose of supplementing the retirement income or for any other purpose. Accordingly, one should ensure that the life insurance policy does not fall under the category of a modified endowment contract (MEC). A modified endowment contract is disadvantageous because it violates the seven-pay premium test as outlined in Section 7702A of the Internal Revenue Code (Tannahill, 2012). Here, when a policy is categorized as a MEC, the cash value of the insurance policy is included in income tax if the owner decides to make withdrawals or obtain a loan. In this case, a withdrawal or loan taken form a MEC is taxable just like in an annuity policy. This tax includes income tax and a 10% penalty, which is not applicable to people aged 59.5 years and policies owned by disabled people. Therefore, as a general rule, it is important to avoid a MEC in case the insurance policy is intended to provide supplemental income upon the insured’s death. On the other hand, it is important for the insured to invest enough money in the insurance policy so that the planned premiums are sufficient enough to cater for the policy benefits, policy premiums, policy charges, and excess premiums for cash accumulation. Therefore, for an insurance policy intended to supplement retirement income, the insured should aim at maximizing cash accumulation and maintaining the required policy benefits (Brenner, 1993).
Experts recommend a variety of techniques for the purpose of accomplishing cash accumulation while providing for the required policy proceeds. First, cash accumulation on the insurance policy can be achieved by minimizing the death benefit. Here, it is important to note that the policy charges increase with an increment in the death benefit. As a result, to allow for cash value accumulation, the policy owner should maintain a smaller death benefit. Secondly, it is recommended that a level death benefit should be chosen. Currently, most universal life policies including variable and indexed universal life policies give the policy owners the opportunity to choose from two different types of death benefit. The first type commonly referred to as Option A entails a level death benefit. The main advantage of this type of death benefit is that it does not increase during the life of the policy unless tax laws are passed in that state . This implies that the cash value of the policy will continue to increase while the amount charged for the insurance decreases (Tannahill). In the end, the insurance policy provides sufficient benefits to cater for the family’s needs upon the insured’s death or incapacitation.
Another important technique that will enable the insured to avoid estate taxes on the life insurance proceeds entails transferring the ownership of the policy to the adult children or an irrevocable life insurance trust (ILIT). However, experts recommend that the ILIT option is more appropriate because it will ensure that the insurance proceeds are used for the intended purposes. Furthermore, an ILIT will ensure that the cash value or the insurance proceeds is not accessed by a bankruptcy trustee or an ex-spouse (McDevitt, 1993). Thus, by transferring the insurance policy to an ILIT, the insured will not only ensure that the proceeds are not subject to the federal estate tax, but he or she will ensure that the money is spent appropriately for the benefit of surviving family members.
A life insurance policy is a contract between the insured and the insurer whereby the insurance company is supposed to pay a specified amount of money to the named beneficiaries upon the insured’s death. This type of insurance policy allows individuals and families to achieve multiple financial goals with limited resources. For instance, the life insurance proceeds can be used to cater for the family’s daily expenses, pay off mortgages, set up a college fund, and settle debts owed by the insured before his or her death. However, from the foregoing discussions, it is evident that life insurance proceeds are not entirely excluded from taxation since they are susceptible to both income and estate taxes. It has been established that when such proceeds are subject to various kinds of taxation, their intended purposes are not always achieved. As a result, it is important to emphasize that the life insurance proceeds should not be taxed because they serve a variety of economic purposes for the families left behind after the death of principal financial providers.
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