Life Insurance and Retirement Planning
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Tax Issues Affecting the Role of Cash Value in Life Insurance
and Retirement Planning
| Tax-Deferred Growth |
| The Tax Court has held that cash values are not constructively received by a
taxpayer when he or she could not reach them without surrendering the policy. The necessity of surrendering the policy constituted a substantial limitation or restriction on their receipt (Theodore H. Cohen, 39 TC 1055, acq. 1964-1 CB-4). |
| FIFO Taxation of Withdrawals |
| Assuming a single premium or periodic premium life insurance contract satisfies the conditions of the “seven-pay test” of IRC Sec. 7702A(b) (ie., not a modified endowment contract), living benefits received from the contract are taxed under the “cost recovery rule,” regardless of when the contract was entered into or when premiums were paid. This means that such amounts received from the contract are included in gross income only to the extent they exceed the investment in the contract (IRC Sec. 7702). |
| Policy Loans Are Income Tax Free |
| Policy loans from life insurance contracts are not treated as distributions, assuming the policy qualifies as life insurance under IRC Sec. 7702 and is not considered a modified endowment contract. Upon policy lapse or surrender, the outstanding loan balance is automatically repaid from policy cash values. This may, however, cause the recognition of taxable income. At death, the death benefit will automatically be reduced by the amount of the outstanding loan, an action that does not cause the recognition of taxable income. |
| Income-Tax-Free Death Benefit |
| As a rule, death benefits are excludable from the beneficiary’s gross income (IRC Sec. 101(a)(1)). |
| Income-Tax-Free Accelerated Death Benefits |
| Depending on current tax law, receiving an accelerated death benefit disbursement may trigger a "taxable event" for the insured. Consult a tax professional about the possible tax implications of accepting a disbursement of accelerated death benefit funds. |
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