The income tax rules for NLUL policies are virtually identical to the tax rules for UL policies, which are essentially the same as the tax rules for other types of life insurance policies. Beneficiaries receive death benefits that, usually, are free of any federal, state, and local income tax. NLUL policies also are subject to the same estate, gift, and generation-skipping transfer taxation rules as all other types of life insurance policies.
Although the income tax rules for living benefits paid from NLUL policies are the same as for living benefits paid from other types of life insurance policies, their generally limited cash value accumulations make this a relatively moot point. In cases where policyowners do surrender NLUL policies with some cash value or are able to withdraw some cash value from NLUL policies, the general cost-recovery rule governs the taxation of these living benefits. The cost-recovery rule, which is sometimes called the First-In First-Out (FIFO) rule, treats amounts received as nontaxable recovery of the policyowner’s investment in the contract. Only after policyowners fully recover their investment in the contract are additional amounts that they receive treated as taxable interest or gain in the policy. Included in this category of living benefits potentially payable from NLUL policies are lump-sum cash settlements of cash surrender values, cash withdrawals, and amounts received on partial surrender. Policyowners include these amounts in gross income only to the extent they exceed their investment in the contract (as reduced by any prior excludable distributions received from the contract). In other words, generally the income tax rules treat nonannuity distributions during life, first, as a return of the policyowner’s investment in the contract and then, only after the owner has recovered the entire investment in the contract, as taxable interest or gain.
Being that the secondary guarantee is the distinguishing feature of NLUL and that NLUL policies generally accumulate little if any cash values, most NLUL policyowners should be seeking guaranteed death benefits at low premium cost rather than enhanced cash-value accumulations and increasing death benefits as is often the case when purchasing regular UL policies. Consequently, the exceptions to the cost-recovery tax rule for payments of living benefits and the tax risks associated with being classified as modified endowment contracts are nearly irrelevant tax considerations for NLUL policyowners.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM