Life & Annuity Taxation and Uses
This topic explains the tax treatment that makes life insurance and annuities attractive planning tools, along with how they are used in qualified retirement plans and business arrangements. Tax rules here are federal and apply nationwide.
Taxation of Life Insurance
Life insurance receives favorable federal tax treatment. Premiums for personal life insurance are generally not tax-deductible. The cash value grows tax-deferred, and policy loans are generally not taxable while the policy stays in force. Most importantly, the death benefit paid to a beneficiary is generally received income-tax-free. Exceptions exist: interest earned on proceeds left with the insurer under a settlement option is taxable, and a policy that becomes a modified endowment contract (MEC) loses some favorable living-benefit tax treatment. The death benefit may still be included in the insured's estate for estate-tax purposes.
Taxation of Annuities
Annuities grow tax-deferred during accumulation. For a nonqualified annuity funded with after-tax dollars, only the earnings are taxable when distributed. Withdrawals during accumulation follow last-in, first-out (LIFO) treatment, so taxable earnings come out first as ordinary income, and a 10% federal penalty may apply before age 59 1/2. During annuitization, the exclusion ratio determines what portion of each payment is a tax-free return of the cost basis and what portion is taxable earnings. A 1035 exchange allows a tax-free transfer between like contracts, such as annuity to annuity or life policy to annuity.
Qualified Plans and Business Uses
Qualified retirement plans (such as 401(k)s, IRAs, and 403(b)s) receive tax advantages because contributions are often pre-tax and growth is tax-deferred, but distributions are then taxed as ordinary income and required minimum distributions apply. Because the entire distribution from a fully pre-tax qualified plan is taxable, annuities inside them are chosen for the income guarantee, not extra tax deferral. Life insurance and annuities also serve business needs: key-person insurance protects a firm against the loss of a vital employee, buy-sell agreements funded with life insurance let surviving owners buy a deceased owner's share, and executive bonus and deferred compensation plans reward key employees.