Taxation of life insurance: five core rules
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Death benefit: income-tax-free (lump sum or installments); only the interest element is taxable.
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Surrender gain above cost basis = ordinary income; dividends tax-free until they exceed premiums.
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Estate inclusion: insured owned the policy, estate is beneficiary, or transfer within 3 years of death.
Modified endowment contracts (MEC) and the 7-pay test
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MEC = policy entered into on/after June 21, 1988 that fails the 7-pay test.
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MEC loans and withdrawals: gain first, taxable, plus 10% before 59½.
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Once a MEC, always a MEC; death benefit remains income-tax-free.
Section 1035 exchanges: which way is allowed
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Allowed: life to life/endowment/annuity; endowment to annuity; annuity to annuity; any to qualified LTC.
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Not allowed: annuity to life insurance (or to endowment); endowment to life.
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No time limit, but it must be a direct contract-for-contract exchange.