Taxation of Personal Life Insurance and Annuities

Pre-Tax and Post-Tax Concepts

• Pre-Tax Dollars: Money invested before taxes.
  • E.g., Contributions to a 401k.
  • Taxed upon withdrawal.
• Post-Tax Dollars: Money invested after taxes.
  • E.g., Contributions to a Roth IRA.
  • Not taxed upon withdrawal if certain conditions are met.

Qualified Plans

• Qualified Plans (IRS Approved)
  • Offer favorable tax treatment.
  • Contributions: Tax-deductible.
  • Requirements:
    • Exclusive benefit of employees.
    • Not catering to prohibited groups.
    • Formally written and communicated.
    • Vesting schedule.
    • IRS approved.
    • Permanent.
• Types of Qualified Plans
  • Traditional IRA
    • Contributions: Tax-deductible.
    • Withdrawals: Begin at 59½, mandatory at 72.
  • Roth IRA
    • Contributions: Non-tax-deductible.
    • Tax-free withdrawals after 5 years.
    • No mandatory withdrawals at 72.
  • SEP IRA
    • For self-employed/small businesses.
    • Contribution: Up to 25% of earned income.
  • SIMPLE IRA
    • For businesses < 100 employees.
    • Employer contributions: Up to 3% of annual salary.
  • 401k
    • Salary reduction plan.
    • Pre-tax contributions, taxed on withdrawal.
  • 403b
    • For non-profits (schools, churches).
    • Contributions: Adjust with inflation.

Taxation of Qualified Plans

• Employer Contributions
  • Tax-deductible for employer.
  • Decrease taxable income for employee that year.
  • Lump-sum distributions: Favorable tax treatment.
• Penalties
  • Early withdrawal (before 59½): 10% penalty.
  • Penalty exceptions: Death, disability, education, first home purchase, catastrophic medical expenses.
• Rollover and Transfers
  • Rollover: Tax-free from one plan to another if directly transferred.
  • 20% withholding if money is given to the individual first.

Taxation of Personal Life Insurance

• Premium Payments
  • Not tax-deductible for personal policies.
  • Business policies (key employee): Not tax-deductible.
• Dividends
  • Return of unused premium: Not taxed.
  • Interest on dividends left with company: Taxed.
• Policy Loans
  • Not considered taxable income.
• Accelerated Benefits
  • Generally tax-free if terminally ill or for medical intervention.
  • Taxed if over certain limit or received as periodic payments.
• Surrender Value
  • Cash value withdrawal: Generally not taxed.
  • Anything beyond premiums paid (interest) is taxable.
• Death Benefits
  • Lump sum to beneficiary: Not taxable.
  • Installments with interest: Interest is taxable.
  • Paid to estate: Federally taxed.
  • Incidence of ownership (policy transferred within 3 years before death): Taxable.
• Modified Endowment Contract (MEC)
  • Overfunding policy fails the 7-pay test.
  • Treated as a MEC: Losses taxation benefits of standard life insurance.
  • Taxes on loans and distributions apply if taken before 59½ with penalties.

Key Takeaways

• Understand difference and implications of pre-tax vs post-tax contributions.
• Know the specifics of qualified retirement plans, their tax benefits, and penalties.
• Be aware of the tax implications for personal life insurance and when benefits are tax-free or taxable.