Insurance Products and Taxes: Keeping Uncle Sam at Bay

    by AAII Staff

    Taxes are a fact of American life, with politicians promising static, higher or lower amounts during election cycles to impress various constituencies.

    Taxes impact many areas of life, including life and disability income insurance. Understanding the relationship between insurance and taxes is important.

    This column addresses several tax issues, with the goal of making you a more astute consumer of insurance.

    Taxation of Disability Income

    Disability income can be obtained from individual policies for the self-employed or small business, such as a medical practice, or it can be from a group policy, typically provided by large corporate employers.

    If individual policy premiums are deducted by the taxpayer, the benefits are included as taxable income. Alternatively the premiums can be an aftertax expense and the benefits are therefore received tax-free.

    Group disability insurance premiums are almost always deducted by the sponsoring corporation, and therefore the benefits are taxable. Recently a cable business channel show reminded viewers to include disability income in their taxable income if paid for by their employer, but this isn’t quite accurate. The issue is not whether the employer paid the premium, but whether the employee allowed it to be tax deductible. It may be possible for individuals to request that the amount of their disability income insurance premium be included in their income with appropriate taxes paid. If this is done, the benefits are tax free. This is excellent risk management if individuals can convince their employer to handle it this way by essentially preparing 1099s for all employees wishing to do this.

    Whether your policy is your own individual insurance or group disability insurance, it is far better risk management to forgo deducting the premiums—clearly you are in better financial health when you are able-bodied and working full time. The additional cost of not deducting disability insurance premiums when you are healthy is well worth the price, when the benefit is tax-free income when you are unable to work.

    Pension-Owned Life Insurance

    Life insurance agents usually claim that life insurance premiums are deductible when owned by a pension plan. This isn’t quite accurate. The contributions to a qualified pension are deductible and the pension may purchase life insurance. Typically, life insurance owned by a pension plan isn’t the great deal its proponents claim, but it isn’t awful either. Generally, there are more disadvantages than advantages, but it depends on what is most important to an individual.

    Here is a summary of factors involved with life insurance being owned by a defined-contribution pension plan:

    • Up to 50% of pension contributions can be used to pay premiums for whole life insurance and up to 25% for universal life. These premiums, being part of the pension contribution, are fully tax-deductible. The equivalent term insurance costs are included in income and the insured pays personal income taxes on this amount. As an insured gets older, the amount of taxable income increases.
    • If the insured dies while participating in the pension plan, the death benefits are income tax free, but the cash values are fully taxable less the cumulative term insurance costs incurred. For example, if the death benefit is $500,000 and the net cash value is $200,000, then $300,000 is not subject to income taxes and $200,000 is taxable as a pension distribution.
    • Life insurance proceeds are included in the insured’s estate.
    • If the assets in the pension plan are transferred to an IRA, the life insurance policy must either be terminated or distributed to the insured. If the policy is distributed, its value (usually the cash value) is fully taxable.

    My experience is that around 70% of individuals faced with this situation will decide not to have life insurance in their pension plans, choosing instead to have their life insurance outside.

    The Advantage of Gifting

    The political forces that prompted Congress to temporarily reduce the costs of dying seem to be reversing. Consensus may be building on increasing the estate and gift tax exemption to an equivalent $3.5 million per spouse, with an estate rate a bit under 50%.

    Regardless of what final action is taken, gifting will remain one of the best methods for transferring assets as long as there isn’t a permanent repeal of the estate tax.

    The reason for this is that, when a taxable gift is made, the amount of the gift tax isn’t counted when the gift is valued. For example, a $1 million taxable gift will incur taxes of $435,000, for a total cost of $1,435,000. The $435,000 tax isn’t part of the gift value. But if there were no gift, the entire $1,435,000 would be transferred at death and hit with the estate tax.

    Continuing this example by taking into account the time value of money will help explain the difference. Let’s say this gifted cash earns the same return (let’s assume 6%) as it would if left inside the estate. The $1 million (after taxes) gift has a value in 10 years of $1,790,848. If no gift had been made, the estate retains the $1,435,000, which has an estate value in 10 years of $2,569,866. The estate tax on $2,569,866 is $1,258,426, leaving heirs with a net of $1,311,440. This is $479,408 less than the gifted value of $1,790,848. Gifts provide excellent estate planning.

    I bring this up in the context of life insurance because aversions to paying gift taxes for the payment of premiums leads some individuals (and some advisors) into using misunderstood life insurance financing methods, such as split-dollar life insurance and premium financing.

    It has been my experience that these financing methods turn messy, primarily because they are not well understood. Whenever possible, these situations should be confronted by analyzing the advantages of stepping up to the plate and making the gifts and paying the taxes to clear up debts so the policies can become financially sound.

    The often misunderstood benefit of taxable gifts also causes some individuals to miss the good planning opportunity of continuing to pay participating whole life premiums rather than giving in to their fondness for having the premiums offset by dividends. A review several years ago of a policy using premium offset showed that if the $280,000 annual premiums were paid, with gift taxes of $140,000, the increase in the death benefits and the gift/estate tax differences produced a $1 million net advantage at the client’s life expectancy in 11 years.

    If you are convinced that estate tax repeal isn’t going to happen, it is a good time to think about gifting for life insurance funding.

    Tax-Deferred Cash Value

    Primary income earners who have maxed out their qualified plan contributions but still are able to invest/save for the medium term to long term and need family protection life insurance should consider the wonderful tax advantages of participating whole life on a super-funded basis.

    Let’s say John, age 42, needs $3 million of principal to protect his family, and has a $50,000 budget for investing/saving to age 65. His $50,000 can be applied to a maximum wholesale version of whole life with initial death benefits of $2.5 million, with the balance of the $3 million need ($500,000) purchased as 20-year term insurance.

    Based on current dividend values, beginning at age 66 John can withdraw his cost basis of $1,150,000 tax-free in 15 installments of $76,667, and at his life expectancy have a death benefit of $7,288,318. All this represents a 6.9% tax-free yield on this asset from beginning to end.

    This whole life asset is protected against significant inflation, as the dividend is reset each year and would rise during inflationary times as interest rates increase. This dual-purpose life insurance asset provides significant safety and an excellent long-term return.

    Avoid Tax Deductible Schemes

    We are into the fourth decade of various schemes promising tax-deductible premiums via Section 79 plans, welfare benefit plans (419 and VEBA) and abusive defined-benefit pensions, to name a few.

    All of these plans have been crushed by the IRS, with many participants paying a heavy price for believing such false claims. No doubt the designers are hard at work right now devising new schemes that will likely suffer the same fate as the predecessors.

    Except for the first $50,000 of group life insurance, there are no legitimate tax-deductible life insurance programs. Save yourself time, and possibly considerable expense, by throwing out anyone who makes tax-deductible premium claims.