Tax treatment of death proceeds - Again!
MR. WATSON: When proceeds paid to an individual are paid out on any kind of installment basis, as would be the case with fixed amount, fixed period, or life income options, a portion of each payment consists of principal and a portion of each payment consists of interest. The portion of proceeds attributed to interest is taxable as ordinary income. The remaining portion of the proceeds representing principal is received tax-free. This method of taxing life insurance proceeds is consistent with what is known as the annuity rule.
MR. WATSON: Under the annuity rule, a fixed unchanging fraction of each payment is considered a return of principal and so is excluded from gross income for tax purposes. So that portion of the proceeds representing principal is received tax-free. The balance of each payment representing interest is taxable as ordinary income. The percentage of each payment to be exempted is determined by dividing the insured's investment in the contract by the expected return.
MR. WATSON: In divided by out.
MR. WATSON: Proceeds paid during the insured's lifetime.
Rule of Constructive Receipt
MR. WATSON: The rule of constructive receipt. If your life insurance policy were to endow, maybe creating a taxable situation, you might think you could tell the company not to send you the money, in order to delay paying the taxes. But, the rule of constructive receipt says "if you could have received the money but chose not to take it you will be taxed as if you took it", so, you might as well take it. You are going to be taxed as if you did take it. This is important with endowment policies, an older type of policy that endowed way before age 95.
MR. WATSON: Ex: I paid $20,000 in total premiums and I am going to get back $50,000, the policy is endowing at, lets say, age 65. I have made a profit (gain) of $30,000.
MR. WATSON: I have to claim that gain this year. Pay taxes on the gain.
MR. WATSON: But I have 60 days after the maturity date to roll it over. I can roll it over, spread it out over my lifetime, and be taxed on a portion of it each year. Spread that $30,000 gain out over my lifetime. Does that make sense?
ALL: Yes.
MR. WATSON: Instead of claiming that whole $30,000 and taking it today, I can roll it over and take a life income option and spread my gains out over my life expectancy.
MR. WATSON: How many days do I have to do it?
ALL: 60.
1035 Exchange
MR. WATSON: Now a 1035 exchange.
MR. WATSON: You know these people who have whole life policies and had them for years. They might have had some gains, and now they want to roll them over into another life insurance policy. If they cashed it in, they would pay taxes on any gains they had. Do you agree?
ALL: Yes.
MR. WATSON: There's a section in the Internal Revenue Code called the 1035 Exchange. It allows you to exchange from like kind to like kind, similar kind to similar kind products, and roll your gains over. You can go from
- a life insurance policy to a life insurance policy, roll your gains over. You can go from
- a life insurance policy to an annuity, and roll your gains over. You can go from
- an annuity to annuity, and roll your gains over
MR. WATSON: But you cannot go from an annuity to a life insurance policy.
Life insurance in the estate
MR. WATSON: The value of any life insurance owned is included in the deceased's estate. Remember, death proceeds are tax free to the beneficiary, but any insurance the guy owned will be included in his estate.
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