Important Tax Implications of Second-to-Die Life Insurance

Survivorship Life (SL) is treated in the same manner as other types of life insurance for income tax purposes. Death benefits are paid tax free. If the policy is not classified as a Modified Endowment Contract (MEC), nonannuity distributions or withdrawals will be taxed on the “cost recovery” or first-in first-out basis. That is, amounts received will be treated as a tax-free recovery of investment in the contract until the entire cost basis is recovered. Once basis is recovered, any further amounts will be taxed at ordinary rates as gain in the policy. Annuity distributions will be taxed as a combination of tax-free recovery of cost basis and taxable interest or gain as described in Code section 72. Loan proceeds are not taxable and, in general, interest paid on policy loans will be treated as nondeductible consumer interest.

If a SL policy is treated as a MEC, lifetime distributions and loans are essentially taxed under the “interest-first” rules applicable to annuities. Additionally, if the policyowner receives distributions prior to age 59½, a 10 percent penalty is imposed on the taxable portion of the distribution. However, in the typical case where an SL policy is part of an estate plan that makes maximum use of the unlimited marital deduction to defer estate taxes until the second death, MEC status may be almost immaterial. In these cases, one has little incentive to withdraw cash values because it could jeopardize the plan. In cases where it is unlikely policyowners will withdraw cash values prior to the second death, tax treatment of the SL policy as a MEC will be of little consequence.

Consequently, it may be advantageous, if the policyowner has sufficient cash, to pay up the policy as quickly as possible, even if doing so results in the policy being treated as a MEC. However, one should be careful to avoid MEC status if the plan contemplates borrowing from the policy to pay premiums. Also, MEC status could lead to adverse consequences if borrowing becomes necessary to finance premiums because dividends are lower than projected and/or term rates are higher than projected in a plan using a large portion of term insurance.

Reproduced with permission.  Copyright The National Underwriter Co. Division of ALM

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