Effective Planning with Life Insurance – Avoid These Common Tax Traps

Penn Mutual

By Penn Mutual | July 12, 2016

Life insurance is a unique financial product that may provide needed liquidity during lifetime and upon death of the insured. The importance of life insurance is reflected in its favorable tax treatment: policy death benefits are exempt from federal income tax, policy cash value grows tax deferred, and can generally be accessed on a tax favored basis*. With proper planning, the death proceeds can also be exempt from federal estate and generation skipping transfer taxes. Due to its tax efficiency, life insurance complements many popular planning strategies and techniques – and many popular planning strategies feature life insurance as part of a comprehensive solution.

However, tax traps can frequently arise in structuring a policy and in common planning contexts. Effective planning should identify, avoid, or remediate planning mistakes and oversights – and preserve the unique tax benefits afforded to policy owners and beneficiaries. Through working with their professional advisors, policy owners and beneficiaries can become familiar with these planning considerations and avoid unexpected or undesirable consequences.

Modified Endowment Contract (MEC) Status

The Modified Endowment Contract (MEC) rules were adopted to discourage sale of life insurance policies as tax shelter investment vehicles. Consequently, there are limits on how much premium can be contributed to a policy relative to the size of the death benefit without potential tax consequences. If a policy becomes a MEC, any amounts distributed from the policy (distributions or loans) are subject to income tax to the extent of investment gain – whether policy is owned by an individual, trust, or other entity. An additional 10 percent tax applies to any distributed gain if the taxpayer is under age 59 ½.

These rules can limit planning effectiveness with MECs in certain circumstances. MEC status is generally undesirable if, based upon planning objectives, access to the policy’s living benefits (cash value) is needed. MEC status may not be detrimental where potential access to policy cash value is not a priority, and the policy otherwise satisfies the planning objectives (e.g., policy is acquired primarily for death benefit protection). The death benefit of MEC policy remains income tax free.

MEC status can also be inadvertently triggered by modifications to existing non-MEC policies, such as adjustments to death benefits or premium payments, or a material change to a grandfathered contract (policy issued before 06-21-1988). Consequently, policy changes involving death benefits or premium payments should be reviewed carefully with an advisor.

Once a policy is or becomes a MEC, it remains a MEC (subject to very limited exceptions). This may limit flexibility if circumstances change and access to cash value is later desired. Before issue, the proposed policy should be evaluated to determine how it is intended to work with the broader long term plan. Understanding the rules applicable to MEC and non MEC policies can minimize unexpected tax consequences, or avoid unintended changes to a policy’s status.

Tax Free Policy Exchanges

An important income tax feature of life insurance is the opportunity to accomplish a tax free exchange of an existing policy for a new policy – without recognition of policy gain (pursuant to IRC section 1035). Policy exchanges can provide significant planning flexibility – especially with the introduction of new or more efficiently priced products, or periodic changes in circumstances, planning objectives and liquidity funding needs – emphasizing the need for life insurance solutions that can adapt to changing circumstances.

IRC section 1035 requires strict compliance, and a basic requirement for a valid tax free exchange is the policy owner and insured (measuring life) after the exchange must be the same as before the exchange. Consequently, a single life policy insuring one individual cannot be exchanged for a survivorship policy which includes another insured. However, two policies on the same insured can be consolidated into one policy insuring the same insured.

The exchange process should be carefully managed. Policy exchanges should be accomplished within the insurance carrier or between carriers without issuance of cash proceeds to the policy owner or insured – otherwise the transaction may not qualify. Also, policies with outstanding loans may trigger income tax unless the loan is extinguished prior to the exchange or the new policy is subject to the same amount of loan. Otherwise an existing loan is considered a taxable distribution, triggering income tax on the lesser of the loan or policy gain.

Advisors can offer value by periodically reviewing the sufficiency of coverage, identifying opportunities to acquire better or more cost effective products, and assisting with the implementation of a compliant tax free exchange.

Transfers for Valuable Consideration

One insidious tax trap that can arise in various planning contexts is the “transfer for value” rule. If a life insurance policy is transferred from one person or entity to another, in return for something of value, then the death benefit (in excess of premiums paid) is subject to income tax – unless an exception is met. “Exempt transferees” are limited to the insured, a partner or partnership of the insured, or a corporation in which the insured is a shareholder or officer. An exception also exists for a transfer where tax law requires the transferee to take the transferor’s basis in the policy (e.g., gift).

What’s tricky is not all transfers for value are obvious. Neither a formal transfer of the policy nor tangible consideration is required. In some circumstances, a transfer for value can occur by naming a beneficiary or giving rights to all or part of the proceeds through a separate agreement. The consequence of triggering the transfer for value rule (without meeting one of the exceptions) is the beneficiary will be subject to income tax on the portion of the death benefit that exceeds the consideration paid for the policy, plus any subsequent premium payments and other amounts paid to maintain the policy.

Both personal and business planning contexts often involve transfers of existing policies to other parties. An understanding the transfer for value rule and its potential tax impact is critical when considering policy transfers. Therefore, before a life insurance policy is transferred, the circumstances should be carefully evaluated in light of the transfer for value rule and its exceptions.

Policy Loans

Policy loans can create unintended tax consequences upon surrender, lapse, or transfer.

If a policy with substantial borrowing is surrendered or lapses, the outstanding loan is treated as a distribution. The policy owner will recognize income to the extent the loan, plus remaining cash value, exceeds basis. Policies with outstanding loans that are kept in force until the insured’s death do not create an income tax problem, and the proceeds will remain income tax free. However, the loan is repaid by reducing the death benefit by the amount of the outstanding loan.

Policy loans can also trigger tax if the policy is transferred (including gifts). A policy loan taken prior to a transfer reduces the policy value for federal gift tax purposes. However, the transferor will recognize income to the extent the loan exceeds the policy’s adjusted basis, triggering income tax on the greater of the loan or policy gain. To avoid income tax on a transfer of a policy with a loan, the transferor could consider repaying at least a portion of the loan so it does not exceed basis at the time of the transfer. Transfer of a policy with an existing loan could also trigger the “transfer for value” rule (causing the death proceeds to be subject to income tax) since the transferor’s discharge of the liability is treated as consideration received – unless an exception applies (e.g., carry over basis, exempt transferee).

It’s important to investigate a policy’s status to avoid inadvertent consequences associated with loans. It is of value to review a policy portfolio regularly with an insurance advisor to check for these issues, be alert to emerging problems, and examine options to avoid unanticipated tax.

Estate Inclusion and “Incidents of Ownership”

Most life insurance acquired by high net worth individuals is held outside the taxable estate. Many of these estates are concentrated in illiquid assets, and these individuals want to be sure that the policies intended to provide liquidity for the estate do not increase the estate tax exposure. Personal ownership of the policy may not be a desirable strategy, as this would include the death proceeds in the insured’s estate. Consequently, third party ownership of the policy is often considered, such as by an irrevocable life insurance trust (ILIT).

If the objective is to exclude the death proceeds from the taxable estate, the insured must also be careful not to retain any “incidents of ownership” in the policy – broadly defined as the right to name or change a beneficiary, surrender or assign the policy or revoke an assignment, receive policy loans, or pledge the policy as collateral for a loan. There are circumstances where an insured retains or acquires incidents of ownership (often unintentionally or inadvertently), or encounters other situations that can trigger estate inclusion.

Incidents of ownership are not always obvious, and indirect incidents of ownership can arise in many planning situations and contexts, including ILIT planning. An insured can possess indirect incidents of ownership where he or she holds certain rights or powers under various agreements or arrangements. Estate inclusion also results if the insured dies within three years of relinquishing any incidents of ownership in a policy (whether held directly or indirectly). Incidents of ownership has no “di minimus” exception – and a single incident of ownership (no matter how minor) can cause estate inclusion of entire death benefit.

Incidents of ownership and estate inclusion can be avoided with appropriate planning, and collaborative engagement among tax, legal and insurance advisors.

The Tax Triangle

In life insurance planning, the so called “tax triangle” is a common trap. The triangle occurs where there are three different parties to a life insurance contract – one party as the insured, a second party as the policy owner, and a third party as the policy beneficiary.

If an insured owns a policy on his or her life, he or she can generally name anyone as the policy beneficiary. However, if another party owns a policy on the insured then generally that same party should also be the beneficiary. Otherwise, upon the insured’s death the policy owner may be treated as making a taxable transfer of the death proceeds to the policy beneficiary – subjecting the death benefit to potential gift tax or income tax, depending upon the situation. In the case of a business or employer owned policy, the death benefit received by the beneficiary may be subject to income tax (e.g., compensation, dividend). In the case of an individual owned policy, the death benefit may be treated as a gift to the beneficiary for federal gift tax purposes.

Life insurance can be a very attractive partner in many planning contexts, and represents a unique liquidity funding tool. Life insurance is also subject to some unique tax rules, and as it’s utilized in various planning situations, unexpected tax consequences can arise.

Clients purchase life insurance with the understanding that the policy and the proceeds will be taxed favorably. However, it is easy to make mistakes that can cause unnecessary tax or financial hardship. With mindful planning, the policy owner and beneficiary can be confident the policy and proceeds will retain favorable tax treatment.

Contact your financial advisor to understand your exposure to any of these or other potential tax traps.

* Provided the policy is not a modified endowment contract

This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual or any of its affiliates. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. Penn Mutual does not provide tax or legal advice.

The information and opinions contained in this material are derived from sources deemed to be reliable but should not be assumed to be accurate or complete. Statements that reflect projections or expectations of future financial or economic performance may be considered forward-looking statements. Actual results may differ significantly. Any forecasts contained in this material are based on various estimates and assumptions of the author alone, and there can be no assurance that such estimates or assumptions will prove accurate.

Investing involves risk, including possible loss of principal. Past performance is no guarantee of future results. All information referenced in preparation of this material has been obtained from sources believed to be reliable, but accuracy and completeness are not guaranteed. There is no representation or warranty as to the accuracy of the information and Penn Mutual shall have no liability for decisions based upon such information.


  • Avatar christina barker says:

    Season’s Greetings,
    I’m the owner of a policy on my ex-husbands’s life. I’m no longer, on a long-term basis, able to pay the increasing policy costs. I wish to sell the policy to minimally benefit from the tens of thousands of dollars I have paid thus far during the lifetime of this policy. I need advice from you about some options I may consider. The main reason I have held onto this policy for such a long time has been to benefit my children, to make up for the deprivation they ecountered after the end of my marriage to their father. He is a healthy man of the age of 62.

    Any help you can offer me at this time would be appreciated,

    • Penn Mutual Penn Mutual says:

      Hi Christina,
      The best person to help you with advice would be your adviser. If you’re not sure who that is, or would like additional assistance, please call our customer service department at 1-800-523-0650 (M-F 8:30 a.m. – 6:00 p.m. ET) so we can help.

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