Life insurance is an attractive tool for estate planning because the proceeds received at death are generally not subject to tax. If you have, or are planning to purchase life insurance, you should be aware that the tax implications will depend on whether it is "exempt" from taxation of the accumulated income or "non-exempt."
Policies issued before Dec. 2, 1982 fall under the "old rule" status. These policies are exempt from accrual taxation. Policies issued after Dec. 1, 1982, fall under the "new rules" and may be exempt or non-exempt.
To distinguish the exempt or non-exempt status of a policy, an exemption test must be administered by the insurance company on each anniversary date of the policy. A policy is considered exempt if its emphasis is "benefits on death." Non-exempt policies are those policies that offer a substantial lifetime investment including annuity contracts. Exempt policies must meet current test requirements and must also meet prospective test requirements for future anniversaries. You can obtain information about the tax status of your policy from your insurance company.
The exempt status of a policy can change for a variety of reasons and each has different consequences. An exempt policy that does not meet the exemption test is then granted a 60-day grace period to return the policy to its exempt policy status. In most cases, this requires withdrawing money from the policy.
The tax on non-exempt policies must be paid at least every three years. Holders of policies acquired after 1989 must pay tax annually. If you are insured under a non-exempt policy, then upon your death investment income generated from this policy that has not yet been taxed will be considered taxable income. The proceeds received on death from an exempt policy, including the income earned under this policy, are not taxable.
Tax may also be payable if you transfer ownership, relinquish or convert your policy. Dividends and policy loans may also have tax consequences that should be looked at carefully.
Exercise extreme care when replacing any policy, particularly an "old-rule" policy, because the tax outcome may be expensive.
The rules and regulations surrounding life insurance policies and taxation change over time. You should talk to your insurance or financial advisor before making any decisions regarding your policy. Members of Advocis have the specialized training essential to help you make the right decisions.