Income Tax on Death Benefit of a Life Insurance Policy

[jmartin]

A profit sharing plan has two participants:John and Jill. They are spouses. Jill has a life insurance policy in the plan and she pays PS-58 every year.

The beneficiary of the policy is the plan itself. The death benefit (which I believe is essentially the portion above the cash value, that is to say the difference between the fair market value and the cash value) is $400,000. Jill passes away, leaving only John as the sole participant in the plan.

I believe that the death benefit portion is not subject to income tax. (Estate Tax is not relevant to the forthcoming questions), where as any amount over the fair market vaule (dividends/interest) is taxed and the amount up to the CSV is taxed. I need to know how that "tax break" could flow through certain situations.....

Q1) Since John is the only other participant, I would assume that the tax break is flowed through to him? Assuming he has $600k additional in the plan ($1M total), would he only pay income tax on the $600k?

Q2) Does it matter if John take a one time lump sum distribution or takes the distribution in installments? If he takes $100,000 installments every year, what portion does he pay income tax (all, none since he hasn't taken $400k total yet, or a pro-rated portion say 10% of it is not taxed since the distribution is 10% of the total balance)?

Q3) Say John wants to waive his right to the death benefit and instead pass it to his beneficiaries: their children. Eventually the children would have to take a lump sum distribution, at the very least as an RMD. If they take RMD's is there a portion of that distribution that is not subject to income tax? That is to say, would the tax break filter down to the children?

Hopefully I am not leaving out too many variables (trying to assist another party). If I need to "rephrase" anything let me know. Thanks in advance!

[Bill Presson]

Clearing up a couple of items: a. I'm assuming the policy is part of Jill's account and not just an investment of the plan. Since she is paying tax on PS 58 costs, this would appear to be the case. If it was just a "key man" life insurance policy, she would not be paying taxes on the cost of insurance.

Q1: The income tax free net death benefit flows through to the beneficiary. If Jack is the beneficiary, then he gets her entire account (death benefit plus regular account accumulations). It has nothing to do with Jack being the only other participant. See above. And his account would, I assume, remain in the plan unless he has a distributable event.

Q2: I believe (but I'm not sure) that the income tax free benefit is lost if he converts to installments. Hopefully someone else knows this. In 25+ years, I've never had someone take installments when an insurance benefit is involved, the beneficiary has always taken the benefit in the current year.

Q3: No idea.

Sorry I couldn't answer everything, but hope this helps some.

[Bird]

I agree with Bill on #1 and prior comments. But FWIW the tax-free part couldn't move to John's account; it would either have to be taken out or left in the plan in Jill's name because the tax-free part is not eligible for rollover.

On #2, I think recovery of the tax-free part would be pro-rated, but why bother? Just take the tax-free part in a lump sum and be done with it. If you really want an annuity buy an annuity with that part, after the lump sum payout.

#3, if John waives, it goes to Jill's contingent beneficiaries, not his. If that happens to be who he wants (and it probably is, their children), great, but the point is that he can't waive and direct that payment. The tax break would go to whoever received the payment.

[mbozek]

I dont understnd what is being proposed under Q3.

Under the IRS rules (see reg. 1.72-16©(4)) the difference between the face amount and the cash surrender value of the LI policy is is treated as death proceeds of LI exempt from income tax. This amount is paid to the beneficary the same as the proceeds from any LI policy. It is not retained in the plan to be paid as an RMD. Only the cash value portion of the LI is trated as a taxable distribution for RMDs. If the designated bene (Jack) disclaims his interest in the death benefits, the LI death proceeds will pass income tax free to the contingent bene designated under the LI policy or if there is no contingent bene to the default bene under the LI contract. If Jack directs the death proceeds to be paid to someone who is not the next successor beneficiary designated under the policy then he will be deemed to have made a taxable gift eligible for the $5M exemption for lifetime gifts.