Buying Life Insurance

Lecture No. 26

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Income Tax Treatment of Life Insurance • Premiums

– In most cases, individuals cannot deduct the premiums they pay for individual life insurance

– The primary exception is for someone who is paying premiums on a life insurance policy owned by a charitable organization

• Death benefits – As a general rule, when an insured dies and a death

benefit is paid • The beneficiary does not have to report the death benefit as

taxable income if the proceeds are paid in a lump sum • When settlement is made through a series of periodic

payments from the insurer – The beneficiary generally can exclude only part of each

payment from taxable income – The amount of each payment that represents a

distribution of the original death benefit is not taxed » While the portion that is due to interest earnings is

subject to taxation

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Income Tax Treatment of Life Insurance• Cash values

– If a life insurance policy with a cash value is terminated before death and the contract is surrendered for cash • It is likely that there will be taxable income that must

be reported in the year of the surrender • The amount of taxable income is the difference

between the cash received at termination and premiums that were paid during life of the contract

– While a cash value policy is in force, the annual increments to the cash value (inside buildup) often escape immediate taxation • In many policies these increments are not taxed until

the policy is surrendered for its cash value

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Income Tax Treatment of Life Insurance• Cash Values

– In some policies however, taxation of part of the inside buildup occurs every year

– The determining factor depends on whether the policy meets the statutory definition of life insurance as specified in the IRC

• Policies that meet this definition are not subject to immediate taxation of their inside buildup

• Cash values of policies that cannot meet the requirements will be partially taxed each year

– According to the IRC, a policy is considered to be life insurance for tax purposes of it meets at least one of two tests

• The intent of both tests is to assure that the cash value in a particular policy is not excessive in relationship to the policy’s death benefit

– Contracts that are primarily savings vehicles and have a only a nominal death benefit will be unable to pass these tests

» Therefore, these contracts will not be granted an income tax advantage for the inside buildup

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Life Insurance Contract Provisions

• The contractual provisions of the life insurance policy are of special significance to the insured

• Because it is through the wise use of these rights that some of the most valuable benefits of protection can be obtained

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Incontestability Clause • If the policy has been in force for a given period and if the

insured has not died during that time – The insurer may not afterward refuse to pay the proceeds, nor

may it cancel or contest the contract, even due to fraud • Thus, if an insured is found to have lied about his or her

physical condition at the time the application was made for life insurance – And this misrepresentation is not discovered until after the

expiration of the incontestability clause • The insurer may neither cancel the policy nor refuse to pay the face

amount if the insured has died from a cause not excluded under the basic terms of the policy

• Serves as a time limit within which the insurer must discover any fraud or misrepresentation in the application or be barred thereafter from asserting what would otherwise be its legal right

• The legal justification for this clause is protection of beneficiaries from doubtful claims by an insurer – That the deceased had made misrepresentations after it

becomes impossible for the deceased to defend against or to deny the allegation

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Suicide Clause

• Partially protects the beneficiary from the financial consequences of suicide

• States that if the insured does not commit suicide for at least a stated period (usually two years after issuance of the contract)– The insurer may not deny liability under the

policy for subsequent suicide • If the suicide occurs within two years of the

issuance of the policy – The insurer’s only obligation is to return without

interest the premiums that have been paid

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Misstatement of Age or Sex

• Misrepresenting one’s age in life insurance is material to accepting the risk and normally would become a defense against payment of the proceeds– If it were not for the incontestability clause

• Without some control over this possibility – It would become possible for people to understate their ages to

obtain lower life insurance premiums • Proof of age is therefore required before proceeds are paid • Under the misstatement-of-age clause

– If it is determined that the policyholder’s age has been misrepresented

• The insurer adjusts the amount of proceeds payable rather than canceling the agreement altogether

• Proceeds will be adjusted in a similar manner through the misstatement-of-sex clause – It is common for females to pay lower premiums than males of

the same age when purchasing life insurance

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Entire Contract Clause

• Provides that the policy, together with the application, constitutes the entire contract between the parties

• Desirable for the protection of the insured and the beneficiary because – Without the clause it might be possible to affect

the rights of the respective parties through changes in the bylaws or in the charter of the insurer

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Assignments • An insured may wish to assign the benefits

of a life insurance policy – Often as collateral for a loan

• Permission of the insurer is not necessary – But the insurer must be properly notified in

writing of an assignment or else is not bound by it

• If the insured dies, the insurer pays the holder of the assignment that part of the proceeds equal to the outstanding debt – Then pays the remainder to the named

beneficiaries

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Dividend Options • Some life insurance policies are

participating– They pay the policyowner dividends

• The dividend is not a distribution of profit but a partial return of the premium payment – Reflects the insurer’s experience with respect to

mortality, investment income, and expenses • Dividends are not taxable to the recipient • Insurers are not required to pay dividends • However, dividends may be substantial

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Cash or Payment of Premium

• A policyowner may specify that all dividends are either to be paid to the policyowner in cash – Or be applied toward the payment of the next

premium due

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Accumulation at Interest

• The insurer may retain the dividends and pay interest on the accumulated amount

• A minimum guaranteed interest rate is stated in the policy – Although insurers often pay more than the guaranteed minimum

• The dividends themselves are not taxable – But interest paid on them through this option is taxable to the

policyowner in the year in which it is credited • When dividends are paid and are not withdrawn prior to the

insured’s death – The accumulated dividends are added to the policy face amount

and are paid to the beneficiary as part of the death benefit • Accumulated dividends distributed as part of the death benefit are

not considered taxable income

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Paid-Up Additions • Policyowners of whole life policies usually

are offered the paid-up additions option – Each dividend is used to purchase as much

single premium whole life insurance as possible • An economical way to buy additional life

insurance – No commission or other acquisition expenses

must be paid • No medical examination or other evidence

of insurability is required • The insurance purchased under this option

provides additional death protection and has a cash value

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One-Year Term Option

• Uses each year’s dividend to purchase as much one-year term insurance as possible

• Insureds can increase their death protection to the maximum extent without additional premium payment

• Sometimes the amount of term insurance may be limited to the size of the policy’s accumulated cash value or its face amount

• Any remaining dividend can be taken under another dividend option

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Nonforfeiture Options

• Guarantee that the savings element in a policy will not be forfeited to the insurer under any circumstances – But will always accrue to the benefit of the

insured • Required by law in all states

– Prior to this requirement there were cases in which aged persons agreed to sell their policies to speculators when they could no longer afford to pay the premiums

– The insured seldom fared well in these transactions

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Cash Value Option

• The policy may be surrendered for cash • A schedule of guaranteed minimum cash

values is included in the policy – Although the actual cash value in policies may

vary considerably from the minimums guaranteed

• Before payment is made, any outstanding indebtedness is subtracted

• The cash is usually paid immediately – Although the insurer has the right to delay

payment for as long as six months – After 30 days the insurer is entitled to interest

on the amount due

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Paid-Up Insurance Option

• The insurer uses the cash value to buy as much single-premium insurance as possible on the life of the insured – Given the size of the cash value

• The same type of insurance is purchased as existed for the original policy – The only difference is that the new death

benefit will be for lower now than before – And no more premiums will be required after

the option is exercised

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Extended-Term Option

• If the insured does not select a nonforfeiture option and has not implemented the automatic premium loan provision – Most insurers automatically place a cash value policy on

the extended-term option • If premiums remain unpaid after expiration of the grace

period • The policy’s cash value is used to purchase term

insurance for as many years and months as are allowed by the rates in effect for the insured’s age when the lapse occurs

• Minimum guarantees regarding this option are included in the policy

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Policy Loans

• Sometimes the policyowner may need access to funds that are only available through the cash value of his or her life insurance policy – And it may not be desirable to terminate the policy

• The cash value may be borrowed from the insurer with the insurance coverage remaining intact

• If the insured dies with an outstanding policy loan – The amount of the loan is subtracted from the policy

proceeds before payment is made to the beneficiary – Otherwise, there is no obligation to repay policy loans

• However, because the insurer calculates premiums on the assumption that interest will be earned on the funds supporting the policy – Interest is charged to anyone--including the policyowner—

who borrows some of these funds – Unpaid interest accumulates and is added to the total

loan outstanding

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Policy Loans

• If the policyowner takes a policy loan but still wants to maintain the full amount of death protection – The one-year term dividend option can be helpful,

assuming that the contract is participating • Because policies without flexible premium

arrangements will lapse after expiration of the grace period if premiums are not paid when due – Many insurers encourage the use of an automatic

premium loan provision • Automatically authorizes the insured to use cash values to

pay unpaid premiums that are due • Policy loans from cash value life insurance

contracts generally are not taxable as income

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Beneficiary Designation • The beneficiary of a life insurance policy

generally must have an insurable interest in the insured’s life at the time the policy is issued

• Attention should be given to the way the beneficiary designation is worded – So that the death benefit will be paid to the

intended person – If children are listed by name, then any

subsequent children born to the insured will be excluded • Thus, is better to say “children of the insured” if the

policy is intended to benefit all children at the time of the insured’s death

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Beneficiary Designation

• Policyowners have the right to change beneficiaries without notice to those affected – Provided that a beneficiary was not named irrevocably

• A revocable beneficiary has no control over the policy – But an irrevocable beneficiary can be changed only if the

beneficiary gives written consent • Contingent beneficiaries

– Will receive the policy proceeds if the primary beneficiary is not alive at the time of the insured’s death

– If both the insured and the primary beneficiary die under circumstances such that it cannot be determined who died first

• The general rule is that the proceeds will be paid to the contingent beneficiaries

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Beneficiary Designation

• If the primary beneficiary clearly survives the insured and then dies – The death benefit is payable to the primary beneficiary’s

estate • A common disaster clause may be used in the

beneficiary designation – Specifies that upon an insured’s death, the insurance

proceeds are to be held by the insurer for a period of time – After that time, if the primary beneficiary is alive

• The proceeds are distributed to that person – Otherwise, the death benefit is paid to the contingent

beneficiaries • In situations where no primary or contingent

beneficiaries are alive when the insured dies – The death benefit is paid to the insured’s estate

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Excluded Causes of Death

• Uncommon for life insurers to exclude coverage for death arising out of specific causes

• One occasionally used exclusion is the war hazard exclusion – During periods when there is a serious threat of war or

other hostilities involving military forces of at least two countries

• Insurers may insert a war hazard exclusion in policies issued to insureds who are either in the military or of an age that may cause them to become subject to military duty

– Eliminates insurance coverage for death that is a direct result of war or other hostile actions between countries

• The aviation hazard exclusion limits coverage for death from aviation activities other than as a fare-paying passenger on a commercial aircraft – Rarely found in policies currently being issued

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Settlement Options

• The different ways in which the policyowner or beneficiary may elect to have the benefits of a policy paid

• Lump-sum option – Proceeds of the life insurance are paid in a lump sum – Vast majority of benefits are paid in this manner – Insurer’s obligations are over

• Fixed-period option – The insurer pays the proceeds in equal installments over

a specific time frame – The size of each installment varies with the

• Desired frequency of payment • Length of the total time period during which payments are to

be made • Interest rate paid by the insurer on proceeds not yet

distributed

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Settlement Options

• Fixed-amount option – Used when a specified amount of income is

desired– The length of time the payments are made is a

function of the size and frequency of each payment and the interest rate paid by the insurer on the proceeds

– Interest earned in excess of the guaranteed level increases the length of time during which payments are made

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Settlement Options

• Interest option – The insurer holds the proceeds of the policy and

pays the beneficiary an income consisting of interest only

– A guaranteed minimum rate is stated in the policy • With excess interest often used to increase the

amount of each payment – The beneficiary usually has the right to

withdraw some or all of the principal amount

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Settlement Options

• Life income options – Several variations guarantee a beneficiary an

income for his or her remaining lifetime – Additional guarantees may be made concerning

the number of payments that will be made or the guaranteed total dollars to be paid • Regardless of how long the beneficiary lives

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Waiver of Premium Benefit

• Provides that insureds who become disabled before a specified age will be excused from paying premiums for as long as the disability continues

• The life insurance policy will have the same cash values, death benefits, and dividends as it would have had if all premiums had been paid

• Policies vary as to how they define disability for this purpose – Many contracts also require a six-month waiting period

after the onset of the disability before premiums are waived

• This is not expensive and is generally recommended as a way of assuring that the life insurance policy will remain intact regardless of the insured’s health

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Accidental Death Benefit

• Makes it possible for the beneficiary to receive an accidental death benefit if the insured dies from an accident

• The size of the accidental death benefit is often equal to the face amount of the underlying policy

• Numerous restrictions exist in this benefit – Common exclusions include death from suicide, death

that occur more than 120 days following an accident, death from illness, death due to war or aviation

• May lead naive insureds to believe that their total death protection has doubled for only an small extra premium

• However, accidents are far from being the leading cause of death – And accidents that satisfy the definitions of the accidental

death benefit are even less common

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Accelerated Death Benefit

• Also known as a living benefit option • Under specified circumstances, a percentage of

the policy’s face amount, discounted for interest, can be paid to the insured before death

• Some insurers consider such payments to terminate all future contractual rights to benefits

• Others allow some or all of any remaining face amount to be paid to the beneficiary when the insured dies

• Accelerated death benefits can be an important income source for persons with terminal illnesses

• Some insurers also offer this option to help pay for an insured’s long-term care needs – An additional agreement known as a long-term care rider

may be attached to a permanent form of coverage

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Accelerated Death Benefit

• Variations exist among insurers regarding – The percentage of the death benefit that can be

paid on an accelerated basis – Whether an additional premium is charged – The types of policies for which the main benefit

options are available – Whether the accelerated death benefit can be

payable in a lump sum or only via installments – Whether complete surrender of all future

policyowner rights accompanies the payment of accelerated benefits

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Accelerated Death Benefit

• One of the factors impeding the growth of living benefit options is a concern that the payment erodes the death benefit protection provided for beneficiaries – Often one of the major reasons for purchasing a life

insurance policy in the first place • Until recently another problem had been the unclear

tax status – Should living benefits be exempt from income taxes in the

same way that death benefits are? • The Health Insurance Portability and Accountability Act of 1996

states that – From December 31, 1996 forward accelerated death benefits are

excluded from taxable income » If a physician certifies that the insured has a terminal illness

that is expected to result in death within 24 months or less

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Spendthrift Trust Clause

• One of the legal rights granted to the life insurance owner in most states is the exemption of death proceeds in cash values from claims of creditors

• Creditors cannot attach the cash value of life insurance for the payment of the insured’s debts– Unless the insured has wrongfully bought or

paid up a life insurance policy with money rightfully subject to creditors’ claims

• Neither may the insured’s creditors attach the death proceeds of life insurance

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Spendthrift Trust Clause• May the beneficiary incur large debts using as

security the right to receive income from life insurance proceeds?– Technically this is possible unless the state law has a

provision to the contrary or unless the law has permitted the attachment of the spendthrift trust clause

• If this clause is attached to a life insurance policy, the beneficiary’s right to that promised income cannot be attached by creditors in any court in the state of residence

• Without such a clause there might be a temptation for an unscrupulous creditor to persuade a beneficiary to purchase goods beyond the ability to pay – Secure in the knowledge that the life insurance could be

attached • Once the proceeds have been paid to the

beneficiary – The protection is lost since the money lose its identity as

life insurance proceeds

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Grace Period and Reinstatement Clauses • Always gives the insured an extra 30 days in which

to pay any premium that is due before lapse takes place

• Can forestall policy lapses as long as sufficient cash values exist to cover the premium due

• Once the policy actually lapses, special application must be made under the reinstatement clause to restore coverage – Contracts may be reinstated within a certain period after

lapse, usually three or five years, with evidence of insurability

– Sometimes a new medical exam must be taken • But in most cases the insured is required only to make a

statement of personal good health at the time of reinstatement

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Grace Period and Reinstatement Clauses• All premiums in arrears must be paid plus interest • Reinstatement reopens the incontestability clause

for another two years – But generally the suicide clause is held not to be

reopened • It is sometimes desirable to reinstate an old policy

rather than to take out a new one because the old policy may have certain provisions – Such as more favorable settlement options, immediate

eligibility for dividends, or higher interest assumptions • Also, no new acquisition costs have to be paid in

the reinstated policy, as they would on a new contract

End of Lecture 26