UL policies that do not run afoul of the modified endowment contract (MEC) rules are taxed in the same manner as other types of life insurance policies. Death benefits are usually paid free of any federal income tax. UL policies are subject to the same income tax and estate, gift, and generation-skipping transfer taxation rules as all other types of life insurance policies.
Living benefits from UL policies are also taxed in the same manner as living benefits from other types of life insurance policies. Annuity-type distributions are taxed under the cost recovery rules of Code section 72 which states that the policyowner’s investment in the contract (generally, total premiums paid less prior nontaxable distributions) is recovered ratably over the expected payout period. Interest paid on or credited to living benefits held by the insurer under an agreement to pay interest is immediately taxable in full.
All other types of living benefits are generally taxed under the “cost recovery rule.” The cost recovery rule, which is sometimes called the FIFO (first-in first-out) rule, treats amounts received as nontaxable recovery of the policyowner’s investment in the contract. Only after the policyowner’s investment is fully recovered are additional amounts received treated as taxable interest or gain in the policy. Included in this category of living benefits are policy dividends, lump-sum cash settlements of cash surrender values, cash withdrawals and amounts received on partial surrender. Such amounts are included in gross income only to the extent they exceed the investment in the contract (as reduced by any prior excludable distributions received from the contract). In other words, nonannuity distributions during life are generally first treated as a return of the policyowner’s investment in the contract, and then as taxable interest or gain.
There is an important exception to the general cost recovery rule for withdrawals within the first 15 years after the policy issue date that are coupled with reductions in death benefits. Since death benefits are generally reduced in an amount equal to any withdrawal of cash values, these withdrawals will generally be fully or partially taxable to the extent of gain in the policy.
Such withdrawals are taxed in whole or in part as ordinary income to the extent “forced out” of the policy as a result of the reduction in the death benefits. The taxable amount depends on when the withdrawal is made:
• Within First Five Years: If the withdrawal takes place within the first five years after policy issue, a very stringent and complex set of tests applies.1 Potentially, a larger portion, or perhaps all, of any withdrawal within the first five years will be taxable if there is gain in the policy.
• Fifth to Fifteenth Years: For withdrawals between the end of the fifth year and the end of the fifteenth year from the issue date, a mathematical test applies. Essentially, the policyowner is taxed on an income-first basis to the extent the cash value before the withdrawal exceeds the maximum allowable cash value under the cash value corridor test for the reduced death benefit after the withdrawal.2 Frequently, only a portion or none of the withdrawal will be taxable in these cases.
Changing from option B (increasing death benefit) to option A (level death benefit) will trigger a test to see whether any amount must be forced out of the policy. In general, option B contracts allow for greater cash accumulations within the policy than option A contracts. Consequently, if a policy with option B has close to the maximum permitted cash value, a switch to option A will generally trigger a taxable distribution. (See Appendices A through G for a complete discussion of the taxation of life insurance.)
The flexibility inherent in UL policies with respect to changes in premiums and death benefits raises the possibility that the policy could become a MEC.3 The penalty for classification as a MEC relates to distributions. If a policy is classified as a MEC, “distributions under the contract” are taxed under the interest-first rule rather than the cost recovery rule. In addition, to the extent taxable, such distributions are subject to a 10 percent penalty if they occur before the policyowner reaches age 59½, dies, or becomes disabled. So MEC categorization of a UL contract means both faster taxation of investment gains and a possible penalty tax for “early” receipt of that growth.
“Distributions under the contract” include nonannuity living benefits (as described above), policy loans, loans secured by the policy, loans used to pay premiums, and dividends taken in cash. “Distributions under the contract” generally do not include dividends used to pay premiums, dividends used to purchase paid-up additions, dividends used to purchase one year term insurance, or the surrender of paid-up additions to pay premiums.
1. An increase in premium payments during the first seven contract years may push the cumulative premiums above the amount permitted under the “seven-pay test.”4
2. A reduction in the death benefit during the first seven contract years triggers a recomputation of the seven-pay test. The seven-pay test is applied retroactively as of the original issue date as if the policy had been issued at the reduced death benefit.
3. A “material” increase of the death benefit at any time triggers a new seven-pay test which is applied prospectively as of the date of the material change.
When issued, most UL policy illustrations show the maximum amount (the seven-pay guideline annual premium limit) that may be paid within the first seven years without having the policy classified as a MEC. If a policyowner inadvertently exceeds that maximum, MEC status can be avoided if excess premiums are returned to the policyowner with interest within 60 days after the end of the contract year in which the excess occurs. The interest will be subject to taxation.5
In general, a reduction in death benefit within the first seven contract years that is caused by and equal in amount to a withdrawal is less likely to cause the policy to fail the recomputed seven-pay test than a death benefit reduction without a withdrawal. However, a policy will fail the seven-pay test if in any year, the cumulative premiums paid to that year exceed the sum of the seven-pay guideline annual premiums to that year. For example, assume the guideline annual premium is $10,000 based on the original death benefit. The policyowner pays $9,000 each year for the first 6 years. In year seven, the policyowner withdraws $36,000, with a corresponding decrease in the death benefit. The recomputed guideline premium is $8,000. The policy now fails the seven-pay test and is a MEC since cumulative premiums paid in just the first year, $9,000, (and through year 6 as well) exceed the sum of the recomputed guideline annual premiums of $8,000.
Any reduction in death benefits attributable to the nonpayment of premiums due under the contract will not trigger a recomputation of the seven-pay test if the benefits are reinstated within 90 days after being reduced.6
A change from option B (face amount plus cash value) to option A (face amount) appears to be a decrease that triggers the look-back rule and a retroactive reapplication of the seven-pay test. In general, one would not expect the switch in options to result in a lower seven-pay limit unless the face amount of insurance was also reduced to less than the face amount at the time of issue. Therefore, switching from option B to option A should not, in general, cause the policy to be reclassified as a MEC.
The term “material” change is not defined in the statute. However, the statute states that it “includes any increase in death benefit under the contract,”7 but not increases attributable to dividends (for paid-up additions), interest credited to the policy’s cash surrender value, increases necessary to maintain the corridor between the death benefit and the cash surrender value required by the definition of life insurance,8 or cost-of-living adjustments. Whether changing from option A to option B constitutes a material change in death benefit is unclear. Other increases in death benefits that require evidence of insurability will be considered material changes that invoke a new seven-pay test. See Appendix D, “Modified Endowment Contracts” for more information.