Tax Treatment of Life Insurance and MECs

November 2, 2018

Perhaps the most well-understood tax aspect of permanent life insurance product (or any life insurance product, for that matter) is that the death benefit is income tax-free. There are, in fact, a few situations where the death benefit may be subject to income taxation and will be discussed later. However, in most instances, the death benefit is income tax-free.

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Another widely known fact is that under current tax law, permanent life insurance cash value increases and dividends paid to the policy directly grow on a tax-deferred basis. It is possible to have the cash value of a life insurance policy grow to an amount much greater than the sum of all premiums paid without income tax consequences.

Taxable Distributions

One tax benefit that is unique to permanent life insurance is the manner in which taxable distributions are determined. Distributions from a permanent insurance policy may be taken in an amount up to and equal to cost basis before triggering income tax. For example, assume that over the years $50,000 of premiums have been paid into a permanent life insurance policy. The first $50,000 actually taken from the policy would be income tax-free as a return of basis. If additional distributions were taken, it would be an income taxable event. Regardless of the type of permanent insurance policy, any distributions received are taxed as ordinary income.

In contrast, annuities and nondeductible IRA’s are taxed on the gain first and the basis is recognized only after all the gains have been taxed. In other words, if $50,000 deposited in an annuity had grown to $75,000, the first dollar taken as a distribution would be subject to income tax. After the first $25,000 had been taken from this annuity, the balance would come back as a return of basis.


This “FIFO” tax treatment for permanent life insurance creates some interesting planning opportunities. In addition to the treatment of distributions, policy loans may be made against the cash value of permanent life insurance. Policy loans (even in excess of cost basis) received is not considered taxable distributions, unless the policy is a MEC.

Any outstanding policy loans at the death of the insured is simply subtracted from the death benefit and the beneficiary receives the balance. This type of treatment allows insurance policies to supplement retirement income on a tax-favorable basis. However, one must take care not to abuse this planning technique or one runs the risk of adverse income tax consequences. If loans become too large, the policyholder may not be able to afford the interest on the loans and may have to lapse the policy. Loan interest may also be borrowed, but there is a limit. If the policy has lapsed, the policyholder would have to pay income tax on the total gain, whether there were any remaining proceeds or not.

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Under certain circumstances, the death benefit of permanent life insurance (and term insurance, for that matter) may be income taxable by running afoul of the transfer for value rule. If an individual (other than the insured) purchases an existing policy for valuable consideration (e.g. money) then the proceeds over and above the amount paid for the policy (plus additional premiums paid minus distributions) could be subject to income tax.

Modified Endowment Contracts (MECs)

The income tax treatment of permanent life insurance policies can also be modified if a policy becomes a Modified Endowment Contract (MEC). Section 7702A was designed for situations where a policyholder paid more into a life insurance contract than is necessary for any given death benefit level; the additional premiums create greater cash value than necessary for the insurer to meet its obligations and that cash value grows without income taxes to the policyholder. There is a 7 Pay Test that provides a guideline for how much may be paid into a policy before it would become a MEC.

If a policy becomes a MEC, it loses some (but not all) of its tax benefits. The tax benefits that are not affected are the income tax-free death benefit and the tax-deferred growth of cash value.

Distributions, on the other hand, are affected as are policy loans. To the extent there is a gain in a MEC, any distributions or loans taken would be taxed until the gains had been fully distributed. Further distributions or loans would be treated as a return of principal. In addition, for any policyholder under 59 ½, there would also be a 10% excise tax, similar to the one imposed upon certain pre-59 ½ distributions on retirement plans.

Once a permanent insurance policy becomes a MEC, it remains a MEC. Even if a 1035 exchange is performed, the new policy becomes a MEC, even if it otherwise would not have been classified as one.

While the death benefit of whole life insurance (and all other forms of life insurance, both permanent life insurance and term insurance) is normally not subject to income tax, it is subject to estate tax. Therefore, in larger estates and or large policy purchases, it becomes necessary to consider the estate tax consequences. Proper planning can generally prevent insurance death benefits from creating estate tax problems.

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