Taxation of Life Insurance and Annuities Worked
Federal income tax decides what an owner keeps from a life policy, an annuity or an IRA, and the answer depends on which rule applies to which dollar. The rules are short. Applying them takes a few lines of arithmetic, and each worked case below shows the lines. Federal dollar limits that change every year are described rather than quoted, because a producer has to read the current figure. The people, companies and amounts in the examples are invented.
Life Insurance While the Insured Lives
Cash value grows without current tax. The tax question arises when money comes out. The starting point is the owner’s investment in the contract, which is the premiums paid less any amounts already received tax free (26 U.S.C. 72(e)(6)). A life policy that is not a modified endowment contract is taxed on a first-in, first-out basis: money out is treated as return of that investment first, and it is taxed only after it exceeds the investment (26 U.S.C. 72(e)(5)).
Dividends and Surrender
Hana Kobayashi owns a participating whole life policy. Over the years she has paid $18,000 in premiums, and she took $2,000 of dividends in cash. A dividend from a participating policy is a return of premium, so it is not income, but it lowers her investment in the contract.
- Investment in the contract: $18,000 minus $2,000, or $16,000.
- She surrenders the policy for a cash value of $21,500.
- Taxable gain: $21,500 minus $16,000, or $5,500, taxed as ordinary income.
Had she left the dividends with the insurer to earn interest, the dividends would still be return of premium, but the interest they earned would be taxable income each year.
A partial withdrawal from a policy that is not a modified endowment contract follows the same order. Once the policy is past its early years, Hana could withdraw $12,000 while her investment is $16,000, and none of it would be taxed. A withdrawal that reduces the death benefit in the policy’s first 15 years can be taxed sooner, because section 7702 recaptures part of the policy’s early cash distributions (26 U.S.C. 7702(f)(7)). The producer tells an owner to ask about the effect on benefits before taking a withdrawal in those years.
Policy Loans and a Lapse
A loan from a policy that is not a modified endowment contract is not a taxable distribution, since the owner is borrowing against the cash value and the interest is charged. The risk appears when the policy ends. Suppose Ibrahim Farouk has paid $20,000 in premiums and borrowed $28,000 from a policy, with no dividends taken. The policy lapses because the loan interest has used up the cash value. The unpaid loan is treated as received when the policy ends, so he is treated as having received $28,000 against an investment of $20,000, and $8,000 is taxable, with no cash in his hand to pay the tax. A producer who sells a policy for its loan feature explains this before the sale.
The Death Benefit and Its Exceptions
Proceeds paid by reason of the insured’s death are excluded from the beneficiary’s gross income (26 U.S.C. 101(a)(1)). Two features of how proceeds are paid and two situations in which the exclusion shrinks are the ones to work.
Proceeds Held at Interest or Paid in Installments
When the insurer holds the proceeds under an agreement to pay interest, the interest is taxable (26 U.S.C. 101(c)). When the proceeds are paid in installments, the insurer’s holding is prorated over the payment period, and each year’s prorated share is excluded, while the rest of each installment is taxable (26 U.S.C. 101(d)(1)).
A beneficiary chooses a fixed-period option on a $200,000 death benefit, payable over 10 years with interest credited at 3%. The level annual installment is $200,000 divided by the 10-year annuity factor at 3%, which is 8.5302, or $23,446.10.
- Excluded each year: $200,000 divided by 10, or $20,000.
- Taxable each year: $23,446.10 minus $20,000, or $3,446.10.
The beneficiary reports $3,446.10 of interest income each year. Over the 10 years she receives $234,461 in all, of which $200,000 is excluded and $34,461 is taxable.
If she had instead left the $200,000 with the insurer under the interest-only option at 3%, the insurer would pay $6,000 a year, and all $6,000 would be taxable each year, because only the interest is paid and the proceeds themselves are not being distributed (26 U.S.C. 101(c)).
Transfer for Value
If a policy is transferred for valuable consideration, the exclusion is limited to what the buyer paid for it plus the premiums the buyer paid afterward (26 U.S.C. 101(a)(2)). The exceptions are a transfer to the insured, to a partner of the insured, to a partnership in which the insured is a partner, or to a corporation in which the insured is a shareholder or officer, and a transfer in which the buyer takes over the seller’s basis (26 U.S.C. 101(a)(2)(A), (B)).
Two cases show where the line falls.
- A company sells a $1,000,000 policy on its owner, Kevin, to Kevin’s brother-in-law for $150,000. The buyer is not the insured, a partner, or a corporation in which Kevin is a shareholder or officer. The buyer pays four annual premiums of $3,000 and Kevin dies. The excludable amount is $150,000 plus $12,000, or $162,000, and $838,000 of the $1,000,000 is taxable.
- A partnership of two owners moves a policy on one partner to the other partner. The buyer is a partner of the insured, so the exception applies and the full $1,000,000 stays tax free.
A transfer to a fellow shareholder who is not a partner of the insured, as when two owners of a corporation swap policies, is the version that catches people. The exceptions name a corporation in which the insured is a shareholder or officer, not the other shareholder personally.
Employer-Owned Policies
When an employer owns a policy on an employee and is a beneficiary, the exclusion is limited to premiums paid unless the notice and consent steps were met before issue and an exception applies (26 U.S.C. 101(j)(1), (2)). A company owns a $1,000,000 policy on a staff accountant who is not a director or highly compensated employee, and has paid $20,000 a year for six years. The employee left the company 18 months earlier and then died.
- Without the notice and consent: the exclusion is limited to $120,000 of premiums, and $880,000 is taxable.
- With written notice and consent before issue, an exception can restore the full exclusion. The exceptions include a death within 12 months of the insured’s last day as an employee, and an amount paid to the insured’s family or designated beneficiary or used to buy the insured’s interest in the business (26 U.S.C. 101(j)(2)). Here 18 months have passed, so the family exception would be the one in play. If the company keeps the proceeds, they are taxable above the premiums.
Modified Endowment Contracts Worked
A policy is a modified endowment contract, an MEC, if it was entered into on or after June 21, 1988 and fails the 7-pay test. The test asks whether the total paid at any time in the first seven years exceeds the sum of the net level premiums that would have paid the policy up in seven years (26 U.S.C. 7702A(a), (b)).
Suppose a whole life policy’s 7-pay premium is $6,000 a year. A buyer pays $10,000 in the first year. At the end of year 1 the limit is $6,000, and $10,000 exceeds it, so the policy is an MEC from the start. The failure is permanent, and it follows the policy into any 1035 exchange. A material change, including an increase in death benefit, starts the test again (26 U.S.C. 7702A(c)(3)).
An MEC is taxed in the reverse order from other life insurance, last in, first out, so income comes out before investment, and loans count as distributions. Suppose the MEC has a cash value of $60,000 and an investment in the contract of $45,000, and the owner, age 50, withdraws $20,000.
- Gain in the policy: $60,000 minus $45,000, or $15,000.
- The first $15,000 withdrawn is taxable income, and the last $5,000 is a return of investment.
- A 10% additional tax applies to the taxable $15,000, which is $1,500, because the owner is under age 59½ and is not disabled (26 U.S.C. 72(v)).
From a policy that is not an MEC the same $20,000 withdrawal would be tax free, because it is less than the $45,000 investment. The death benefit of an MEC is still income tax free.
Annuities
Accumulation and the Penalty
For a non-qualified annuity, a withdrawal before the annuity starting date is taxed income first. The amount treated as income is the contract’s cash value less the investment in the contract (26 U.S.C. 72(e)(2)(B), (e)(3)), and a loan or pledge of the contract is treated as a withdrawal (26 U.S.C. 72(e)(4)(A)).
An annuity has a cash value of $150,000 and an investment of $100,000. The owner, age 52, withdraws $30,000. The gain is $50,000, so all $30,000 is taxable, and a 10% additional tax of $3,000 applies because the owner is under 59½ (26 U.S.C. 72(q)(1)). The penalty does not apply to a distribution made on or after age 59½, on or after the holder’s death, because of disability, as part of substantially equal payments for life or life expectancy, or under an immediate annuity (26 U.S.C. 72(q)(2)).
The Annuity Phase and the Exclusion Ratio
Once payments are received as an annuity, each payment is part return of investment and part income. The exclusion ratio is the investment in the contract divided by the expected return (26 U.S.C. 72(b)(1)). If payments depend on life expectancy, the expected return is the annual payment times a multiple from tables the Treasury prescribes. If they are payable for a fixed period, the expected return is the sum of the payments (26 U.S.C. 72(c)(3)).
A life annuity. Marguerite Delacroix invested $120,000 and starts a life annuity of $800 a month. Assume the Treasury table gives a multiple of 20.0 for her age, a figure used here for the example.
- Expected return: $800 × 12 × 20.0, or $192,000.
- Exclusion ratio: $120,000 divided by $192,000, or 62.5%.
- Each payment: $500 excluded and $300 taxable.
- The exclusion stops when she has recovered $120,000, after 240 payments of $500. After that, each $800 payment is fully taxable (26 U.S.C. 72(b)(2)).
- If she dies after 100 payments, she has recovered $50,000, and the unrecovered $70,000 is a deduction on her final return (26 U.S.C. 72(b)(3)).
A period certain annuity. For $1,500 a month for 10 years, the expected return is $180,000. With the same $120,000 investment the ratio is 66.67%, so $1,000 of each payment is excluded and $500 is taxable.
At the Owner’s Death
A contract is not treated as an annuity unless it requires distribution after the holder’s death. If the holder dies before the annuity starting date, the entire interest must be distributed within 5 years, unless a designated beneficiary takes it over life or life expectancy, starting within a year of death. A surviving spouse who is the beneficiary steps into the holder’s place (26 U.S.C. 72(s)(1), (2), (3)). If the holder dies after payments begin, the remainder is paid at least as fast as the method in use.
Corporate-Owned Annuities
An annuity held by someone who is not a natural person is not treated as an annuity for tax purposes. The owner is taxed each year on the increase in value (26 U.S.C. 72(u)(1)). A company buys a deferred annuity for $500,000, and at year-end the net surrender value is $525,000, so $25,000 is ordinary income that year even though nothing was withdrawn. The rule does not apply to an immediate annuity, to an annuity held in a retirement plan, or to one held by an entity as the agent of a natural person (26 U.S.C. 72(u)(1), (3)).
Employer Plan Distributions and Age
A distribution from a qualified retirement plan is taxed as ordinary income, and one taken before age 59½ carries the 10% additional tax unless an exception applies (26 U.S.C. 72(t)(1), (2)). The exceptions differ between an employer plan and an IRA, and a transfer between them can change the result. Lena Hoffman separates from service at age 56 and needs $40,000.
- From her employer’s 401(k) the distribution is ordinary income of $40,000, with no additional tax, because it is made after separation from service at or after age 55 (26 U.S.C. 72(t)(2)(A)(v)).
- Had she first rolled the account into an IRA, the same $40,000 would be ordinary income and also subject to a 10% additional tax of $4,000, since an IRA has no separation-at-55 exception.
A producer or planner who suggests the rollover without asking when the money will be needed has made a $4,000 mistake. Required distributions from a traditional IRA or qualified plan begin by April 1 of the year after the owner reaches the required age, and a Roth IRA has none during the owner’s life.
Individual Retirement Accounts
Traditional IRA Contributions and Deductions
Anyone with earned income can contribute to a traditional IRA, and a spouse with little or no income can have a spousal IRA funded from the couple’s combined earned income. The limit is a dollar amount set each year, higher for an individual age 50 or older, and it applies to traditional and Roth contributions together. A producer reads the current figure from the IRS before quoting one.
Whether the contribution is deductible depends on whether the individual, or a spouse, is covered by a retirement plan at work and on modified adjusted gross income. If neither the individual nor a spouse is covered, the full amount is deductible at any income. If one is, the full amount is deductible at low income, a range of income phases the deduction out, and above it there is no deduction. The ranges change each year and are read from the current IRS tables. A nondeductible contribution is still allowed, and it becomes the investment in the IRA, which is recovered tax free later.
An individual covered at work whose income is above the phase-out range contributes $4,200 nondeductible. The account grows to $5,100, and the owner withdraws everything. Taxable: $5,100 minus $4,200, or $900.
Traditional IRA Distributions
Distributions from a deductible IRA are ordinary income. Before age 59½ a 10% additional tax applies, with exceptions for death, disability and substantially equal periodic payments, and for an IRA only, qualified higher education expenses, a first-time home purchase and health insurance premiums while unemployed (26 U.S.C. 72(t)). An individual age 45 takes $10,000 from a deductible IRA. The whole $10,000 is taxable and the penalty is $1,000. From an employer plan, a distribution after separation from service at 55 or later escapes the penalty (26 U.S.C. 72(t)(2)(A)(v)), and the IRA has no such exception. Annuity payments from an IRA are fully taxable to the extent the owner has no investment in it.
The beneficiary of a traditional IRA pays income tax on distributions. A surviving spouse can treat the IRA as her own or roll it over. A non-spouse beneficiary cannot treat it as his own. An eligible designated beneficiary, such as a minor child of the owner, a disabled or chronically ill person, or someone not more than 10 years younger than the owner, may take distributions over life expectancy. Others must empty the account by December 31 of the year containing the tenth anniversary of the owner’s death (IRS Publication 590-B).
Roth IRAs
A Roth IRA contribution is never deductible, so it is after-tax money (26 U.S.C. 408A(c)(1)). A qualified distribution is tax free. It must come at least five taxable years after the first Roth contribution, and on or after age 59½, death, disability, or for a first-time home purchase (26 U.S.C. 408A(d)(2)). The contribution limit is the same dollar limit as the traditional IRA, reduced by what the individual contributes to other IRAs, and income above a range reduces it further.
Distributions come out in a fixed order, contributions first (26 U.S.C. 408A(d)(4)). An owner, age 50, has contributed $30,000 to a Roth IRA, and the account holds $42,000. She withdraws $35,000 before the five-year period ends and not for a qualifying reason.
- The first $30,000 is a return of contributions, tax free.
- The next $5,000 is earnings, and it is taxable.
- The 10% additional tax applies to the $5,000, which is $500.
A beneficiary’s distribution counts as qualified if the five-year period has been met. Roth IRAs have no required distributions during the owner’s life.
Rollovers and Section 1035 Exchanges
An IRA owner who receives a distribution has 60 days to roll it over. A distribution paid on March 3, 2026 has to be redeposited by May 2, 2026. A direct trustee-to-trustee transfer avoids the 60-day rule, and an individual may do only one IRA-to-IRA rollover in any 12 months.
A section 1035 exchange moves a policy or annuity to another with no gain recognized. A life policy may be exchanged for another life policy, an endowment, an annuity or a qualified long-term care contract. An annuity may be exchanged only for another annuity or a qualified long-term care contract, and never for a life policy (26 U.S.C. 1035(a)). Karl Brandt’s whole life policy has a cash value of $40,000 and premiums of $25,000. He exchanges it for an annuity directly with the new insurer.
- Gain not recognized: $40,000 minus $25,000, or $15,000.
- His investment in the annuity is $25,000.
- Years later he surrenders it for $46,000, and the taxable gain is $46,000 minus $25,000, or $21,000.
If he had received $3,000 in cash as part of the exchange, that cash would be taxable up to the gain (26 U.S.C. 1035(d)(1)). An MEC that is exchanged stays an MEC (26 U.S.C. 7702A(a)(2)).
The five sources compare as follows.
| Source | What comes out first | Loans | Additional tax before 59½ |
|---|---|---|---|
| Life policy, not an MEC | Investment in the contract, tax free | Not a distribution | None |
| Life policy that is an MEC | Income, taxable | Treated as a distribution | 10% on the taxable part (72(v)) |
| Non-qualified annuity | Income, taxable | Treated as a distribution | 10% on the taxable part (72(q)) |
| Traditional IRA | All taxable unless nondeductible basis exists | Borrowing from an IRA annuity disqualifies it (408(e)(3)) | 10% on the taxable part (72(t)) |
| Roth IRA | Contributions, tax free | Same rule as a traditional IRA | 10% on earnings only if the distribution is not qualified |
Lesson summary
- A life policy that is not an MEC is taxed first in, first out. Investment in the contract is premiums less amounts received tax free, and a surrender is taxed only on the excess.
- A policy that lapses with a loan outstanding can produce taxable gain without any cash.
- Death proceeds are excluded from income. Interest paid on proceeds held by the insurer is taxable, and installments are prorated.
- A transfer for value limits the exclusion to the price and later premiums unless an exception applies. An employer-owned policy without notice and consent is limited to premiums.
- A policy that fails the 7-pay test is an MEC, and its distributions and loans are taxed income first with a 10% additional tax before age 59½.
- A non-qualified annuity withdrawal is taxed income first, and the exclusion ratio splits each annuity payment into return of investment and income.
- A corporate-owned annuity is taxed on the yearly increase unless an exception applies.
- A traditional IRA contribution is deductible depending on plan coverage and income, and distributions are taxed. A Roth IRA is not deductible and a qualified distribution is tax free. A section 1035 exchange defers gain, and an annuity cannot be exchanged for a life policy.