LIFE INSURANCE TAX FEATURES

There are as many life insurance tax benefits as there are kinds of life insurance - and even a few more in addition. Here are the biggest and best:

GROUP INSURANCE

Group term insurance is life insurance your employer buys on your behalf. As long as your coverage does not exceed $50,000, you are not taxed on the premiums the employer pays. However, if the amount of your coverage is more than $50,000, you are taxed on part of the premiums.

If your coverage exceeds $50,000, the taxable benefit is calculated according to IRS tables. You pay some tax for the extra coverage, but the cost (in taxes) is far less than the cost of similar coverage outside the company.

For example, say you are age 39 and have $150,000 group term insurance paid by the employer. The employer may pay premiums of $400 a year. However, you are taxed (from the IRS Table I) on only $108 per year for the extra $100,000 in coverage. Your tax might be only $30. Note that key employees could be taxed on the first $50,000 of coverage if the insurance plan discriminates in their favor, although that is rarely the case.

UNIVERSAL LIFE INSURANCE

Universal life is a form of whole life that combines insurance protection with an investment account. Example: Jones contracts with a life insurance company for a universal whole life policy for a $1,500 annual premium. The cost of the insurance part of the policy might be only $300. The insurance company will take the extra $1,200 and invest it at market rate interest.

The interest earned in a universal life policy stays in the policy. It is not taxable until you take it out, and then you only pay tax if the money removed is greater than the full amount of premiums paid. Bonus: You may use the money without tax by borrowing it.

VARIABLE LIFE INSURANCE

In this type of contract a small portion of each premium goes to administration of the contract, a portion is allocated to death benefit purchased at net rates, and the balance is invested. The policy owner selects the investment from among the choices offered by the insurance company. The growth, dividends and capital growth are not taxable to the policy owner so long as they retain the policy.

This differs from the tax treatment of a other investments in which the owner must pay tax on dividends or capital gains distributions - and if mutual fund investment accounts are switched - all gains must be taxed. Over a long time, this feature represents a significant advantage to the owner of a variable life policy.

ALIMONY INSURANCE

This may be insurance on your life, with the proceeds payable to an ex-spouse, to guarantee alimony payments. The premiums paid are deductible as alimony, and taxable to the ex-spouse. Caution: If the separation agreement and the policy are not properly worded, the proceeds may be included in your estate, even though they are paid to the ex-spouse.

BUY-SELL INSURANCE

Buy-sell insurance is used by stockholders of a closely held corporation or partners of a partnership who have an agreement that when one of them dies, the proceeds of the life insurance policy will be used to buy the deceased’s stock or partnership interest from his or her estate.

The stock is revalued to market value in the deceased’s estate; it gets a stepped-up basis for tax purposes. (If the stock costs $1,000 and the life insurance proceeds are $100,000, the stock is valued in the estate at $100,000.) When the estate sells the stock back to the company, no income tax is payable on the gain. The proceeds of the policy may, however, be subject to estate tax when transferred to the estate in exchange for the stock. However, the stock would have been taxable, so there is not a difference - except that the value has now been fixed at a specific amount.

When the corporation owns the policy, there is another benefit: cheaper insurance. The employee is using the corporation’s money, which is subject to a lower tax, to pay premiums on the policy. Since the company may be in a lower tax bracket, it needs to earn less money than the employee to pay a premium of the same size.

CROSS-PURCHASED INSURANCE

Cross-purchased insurance is used when there are two owners of a closely held corporation or partnership. Instead of having the corporation own the policy and pay the premiums, each stockholder or partner owns the policy on the other’s life.

When one of the owners dies, the survivor gets the insurance proceeds tax-free. He or she uses the proceeds to buy the other owner’s partnership interest or stock from the estate. Now the surviving partner owns 100% of the company. The cost basis now includes the insurance proceeds.

When the company is sold, the owner escapes tax on the purchase price to the extent of his or her revised cost basis.

WHO SHOULD OWN AN INSURANCE POLICY?

If you own the policy yourself, or if you retain any ownership rights over the policy at your death, the proceeds will be included in your estate and may be subject to estate tax. If your spouse owns the policy and you die first, the proceeds become part of his or her estate, subject to estate tax.

The best tax strategy may be to set up a trust for your children and let the trust own the policy. Make annual gifts to the trust to pay premiums. The trustee pays your surviving spouse the income for life. The principal, on the spouse’s death, goes to the children. This keeps the proceeds out of both your and your spouse’s estate.

Watch the three year rule: The proceeds of a policy will be included in your estate if you assign it to someone other than your spouse within three years before death. To make a quick sale, many insurance salespeople will have you purchase a policy in your name and tell you it can be assigned to your wife or a trust later. However, if you die within three years, the proceeds will be taxable in your estate. Never buy a policy from a life insurance salesman who takes this approach.

POLICY LOAN INTEREST

Interest on policy loans used to be deductible for individuals. Unfortunately, this was phased out as part of Tax Reform. However, businesses may still deduct policy loan interest.

Source: Tax Facts 2003, National Underwriter Company

Material discussed is meant for general illustration and/or informational purposes only and it is not to be construed as tax, legal, or investment advice. Although the information has been gathered from sources believed to be reliable, please note that individual situations can vary therefore, the information should be relied upon when coordinated with individual professional advice.