Recognize retirement and tax boundaries

What you will learn

• Distinguish qualified retirement plans from nonqualified arrangements without assuming all contributions are pre-tax.
• Classify life insurance premiums, death proceeds, interest, dividends and surrender proceeds before applying a tax rule.
• Explain why taxable group-term insurance cost is not the policy's face amount.
• Recognize a modified endowment contract and explain its distribution rules and additional-tax exceptions.

Before you start

You should know the difference between premiums, cash value and death benefits, and between an individual policy and group coverage. Recall that an annuity's accumulation phase differs from its income-payment phase.

Nina receives a retirement-plan statement, a life insurance dividend notice and an employer benefits summary. All three mention money, but they do not describe the same tax event. First identify the arrangement and the payment. Then ask whether the amount is a contribution, returned investment, earnings, insurance cost or a death benefit. This lesson covers federal income-tax concepts, not instructions for preparing an individual return.

Start with the retirement arrangement

A qualified employer retirement plan meets Internal Revenue Code requirements and receives special tax treatment. Examples include qualifying pension, profit-sharing and 401(k) plans. Qualification involves requirements for the plan, not merely an employee's decision to save for retirement.

Traditional pre-tax salary deferrals generally avoid current income taxation, with taxation deferred until distribution. But qualified does not mean every contribution is pre-tax. A plan can offer a designated Roth account: those contributions are included in current income, while qualified Roth distributions, including earnings, are excluded from income. The word qualified in "qualified Roth distribution" describes a distribution that meets the relevant conditions; it is not a promise that every withdrawal is tax-free.

Nonqualified means the arrangement does not receive the same qualified-plan treatment; it does not mean illegal or useless. Consider a commercial annuity purchased outside a qualified retirement plan with after-tax money. The owner's investment is not taxed again when returned, but earnings can be taxable. For a withdrawal before annuity payments begin, earnings generally come out first. Once annuity payments begin, different rules allocate investment and taxable income. Do not apply the withdrawal rule mechanically to each annuity payment.

An employer's nonqualified deferred-compensation arrangement is another category, not simply another name for a personally purchased annuity. Its tax timing depends on its terms and applicable rules. Neither "nonqualified means everything is immediately taxable" nor "nonqualified means all contributions are deductible" is a reliable shortcut.

Case: Nina chooses Roth

Nina's employer offers both traditional pre-tax and designated Roth contributions within its qualified 401(k) plan. She chooses Roth. A coworker says her choice must make the plan nonqualified because her contribution is taxed now. What is wrong with that reasoning?

Separate premiums from benefits

Ordinary personal life insurance premiums generally are not deductible. Calling the policy "retirement protection" does not turn its premium into a retirement-plan deduction or a medical expense.

Business ownership is not an automatic deduction either. A business generally cannot deduct life insurance premiums when it is directly or indirectly a beneficiary. That matters for a typical business-owned key-person policy. In contrast, employee life insurance premiums can generally be a deductible business expense when the business is not directly or indirectly the beneficiary, subject to the applicable rules. Identify the arrangement and beneficiary instead of treating every employer payment alike.

Death proceeds paid by reason of an insured's death are generally excluded from the recipient's gross income. Interest is different. If proceeds earn interest before payment, that interest generally is taxable even though the death benefit is excluded. Special rules, including certain transfers for value and employer-owned contracts, can limit the exclusion. This is an income-tax rule only; other federal taxes are outside this lesson.

Case: One check, two components

Nina receives a check consisting of a $120,000 death benefit and $900 of separately identified interest. Assume the ordinary death-benefit exclusion applies. Is the whole $120,900 excluded from income because it arrived in one check?

Distinguish returned premiums from earnings

An ordinary participating policy dividend is not the same thing as a stock dividend. For a life insurance policy that is not a modified endowment contract, distributed dividends generally return premiums and are not taxable until they exceed total net premiums paid. A dividend used toward premiums is not automatically taxable income. Interest earned on dividends left with the insurer, however, is taxable interest.

On a surrender, compare proceeds with the investment in the contract, often called tax basis. Basis is not always the simple sum of every premium ever paid: prior refunds, dividends and other adjustments can matter. Surrender proceeds above that investment generally are taxable. Do not tax the entire surrender payment merely because the insurer sends cash, and do not assume the entire payment is tax-free because premiums were paid with after-tax dollars.

Case: Nina surrenders a different policy

For this example, the insurer's records establish an adjusted investment in the contract of $18,000. Nina receives $23,000 on a full surrender, with no other complication. How much exceeds her investment? Would $300 of interest on dividends left on deposit with the insurer be treated as another return of premium?

Value group-term coverage as a benefit cost

Under the ordinary federal rule for employer-carried group-term life insurance, the cost of up to $50,000 of coverage is excluded from income. For coverage above that amount, the taxable amount is the imputed cost determined under the IRS rules and table, reduced as applicable by employee payments. Imputed cost is a tax value assigned to the insurance protection. It is not the death benefit and is not necessarily the premium the insurer actually charged.

Nina's ordinary employer-carried group-term coverage is $80,000. Subtracting $50,000 leaves $30,000 of coverage whose cost must be considered. It does not create $30,000 of taxable wages. The applicable table and employee contributions determine the includible cost. Special rules can change the ordinary exclusion, including rules for certain discriminatory plans benefiting key employees.

Case: Coverage versus income

A benefits worksheet lists $70,000 of ordinary employer-carried group-term coverage. An employee says, "The first $50,000 is excluded, so I owe income tax on $20,000." What step is missing?

Recognize a modified endowment contract

A modified endowment contract, or MEC, is a life insurance contract with a different tax treatment for certain lifetime distributions. One route to MEC status is failure of the statutory seven-pay test. At any time during the first seven contract years, the test compares cumulative payments with the net level premiums that would have been paid by that time if the contract provided paid-up future benefits after seven level annual premiums. Paying too much too early can fail the test.

This is a funding-limit test, not a rule that the seventh payment causes MEC status or that any policy paid for in fewer than seven installments must be a MEC. Exchanges from an existing MEC and certain contract changes also matter; material changes can trigger new testing. The insurer's actual testing is more reliable than counting premium checks.

For ordinary non-annuity distributions from a MEC, taxable earnings generally come out before investment. Loans and certain assignments or pledges can also be treated as distributions; calling a transaction a loan does not necessarily avoid the rule. This differs from treating an ordinary non-MEC life insurance dividend as a return of premiums.

The taxable portion of a MEC distribution can also face a 10% additional tax. Exceptions include distributions at or after age 59½, qualifying disability, and qualifying substantially equal periodic payments made at least annually over the prescribed life or life-expectancy period. An exception to the additional tax does not erase ordinary income tax on earnings.

MEC status does not, by itself, cancel the policy's life insurance status or turn its entire death benefit into taxable income. The general death-benefit exclusion and its usual exceptions remain a separate question from the treatment of lifetime distributions.

Work through a MEC distribution

Suppose Nina has a MEC with a stipulated investment of $24,000 and cash value of $31,000 immediately before a distribution. The gain is $7,000. Assume the ordinary MEC distribution rules apply and there are no other adjustments.

She takes $4,000. Because earnings come out first, all $4,000 is taxable income. If she is age 50 and no additional-tax exception applies, the 10% additional tax is $400. That is in addition to the income tax, not a replacement for it.

Now change only her age to 60. The $4,000 remains taxable income, but the age exception removes the 10% additional tax. Changing age did not change whether the distribution represented earnings.

Case: A larger distribution

Use the same $24,000 investment and $31,000 cash value, but assume the first distribution is $9,000 rather than $4,000. The owner is age 50 and no additional-tax exception applies. How much is taxable, how much returns investment, and how large is the additional tax?

Case: A label is not a tax rule

A business buys key-person life insurance naming itself beneficiary. Its manager says, "Every business premium is deductible, and a MEC loses the death-benefit exclusion anyway." Identify both errors.

Use a classification checklist

• Identify the arrangement: qualified plan, designated Roth account, nonqualified annuity or life policy.
• Identify the event: premium, dividend, interest, surrender, lifetime distribution or death benefit.
• Separate returned investment from earnings. Use adjusted basis rather than guessing from historical premiums.
• For group-term insurance, distinguish the coverage amount from its taxable cost.
• For a MEC, apply earnings-first treatment, then consider the additional tax and its exceptions separately.

Sources

IRS Publication 575, qualified plans and annuity distribution rules: https://www.irs.gov/publications/p575
IRS designated Roth accounts: https://www.irs.gov/retirement-plans/roth-acct-in-your-retirement-plan
IRS Publication 525, life insurance, retirement and group-term benefits: https://www.irs.gov/publications/p525
IRS Publication 502, excluded insurance premiums: https://www.irs.gov/publications/p502
IRS Publication 334, business insurance expenses: https://www.irs.gov/publications/p334
IRS life insurance proceeds FAQ: https://www.irs.gov/faqs/interest-dividends-other-types-of-income/life-insurance-disability-insurance-proceeds/life-insurance-disability-insurance-proceeds
IRS Publication 550, life insurance dividends and interest: https://www.irs.gov/publications/p550
IRS employer-carried group-term life insurance: https://www.irs.gov/government-entities/federal-state-local-governments/group-term-life-insurance
IRS Revenue Ruling 2007-38, MEC law and analysis: https://www.irs.gov/irb/2007-25_IRB
Cornell Legal Information Institute, 26 USC 401: https://www.law.cornell.edu/uscode/text/26/401
Cornell Legal Information Institute, 26 USC 402A: https://www.law.cornell.edu/uscode/text/26/402A
Cornell Legal Information Institute, 26 USC 72: https://www.law.cornell.edu/uscode/text/26/72
Cornell Legal Information Institute, 26 USC 101: https://www.law.cornell.edu/uscode/text/26/101
Cornell Legal Information Institute, 26 USC 262: https://www.law.cornell.edu/uscode/text/26/262
Cornell Legal Information Institute, 26 USC 264: https://www.law.cornell.edu/uscode/text/26/264
Cornell Legal Information Institute, 26 USC 162: https://www.law.cornell.edu/uscode/text/26/162
Cornell Legal Information Institute, 26 USC 79: https://www.law.cornell.edu/uscode/text/26/79
Cornell Legal Information Institute, 26 USC 7702A: https://www.law.cornell.edu/uscode/text/26/7702A