Tax Planning with Life Insurance For Caterpillar Employees

What Is Tax Planning With Life Insurance?

Having life insurance can help you achieve a variety of objectives, and tax planning in conjunction with life insurance can minimize the tax implications of your life insurance decisions. Depending on the type of insurance coverage you choose, the tax planning tools involving life insurance will vary. In order to make informed insurance tax planning decisions, Caterpillar clients must first comprehend topics such as the tax-deferred accumulation of cash value, the taxation of withdrawals, proceeds, loans, and dividends, and the premium deductibility. In addition, your insurance tax planning should include an understanding of the benefits and drawbacks of simple life insurance, modified endowment contracts, personal life insurance trusts, business use of life insurance, and life insurance as part of a charitable giving plan.

What Is The Tax-Deferred Buildup of Cash Value?

Even if the policy terminates due to a mortality claim, the cash value increase in an insurance policy is generally not taxable income as long as the policy remains in force. Therefore, the accumulation (increase) of cash value represents deferred income.

What Are The General Tax Rules For Life Insurance?

A contract cannot be considered a life insurance contract (and thus eligible for favorable tax treatment) for federal income tax purposes unless it is treated as a life insurance contract under applicable state law and meets either the cash value accumulation test or the cash value corridor test.

Depending on the form of distribution (i.e., a lifetime distribution, death proceeds, or dividends), the tax treatment of your life insurance policy will vary. For federal income tax purposes, lifetime distributions (other than loans) from such cash-value life insurance policies are generally treated as first-in, first-out (FIFO) distributions. In other terms, the money you withdraw is initially considered your nontaxable basis or investment in the contract. Only distributions in excess of your basis are considered taxable.

Distributions

We would now like to discuss distribution categories with our Caterpillar clients. A lifetime distribution is any payment of the cash value of a life insurance policy made during the insured's lifespan, as opposed to the payment of the proceeds after the insured's death. There are three principal categories of lifetime distributions: loans, partial surrenders, and complete surrenders.

• The policyholder obtains a loan from the insurance company using the cash surrender value of his or her policy as collateral. Until the debt is repaid, the loan balance reduces both the cash surrender value of the policy and the death benefit. Because they are not considered distributions for tax purposes, policy loans typically do not trigger an immediate income tax liability for the policy owner. As long as your policy remains in force, the loan proceeds are not considered taxable income. However, Caterpillar clients should be aware that if their policy lapses or they surrender the policy, they will be required to include the outstanding loan proceeds in their gross income to the extent that the loan proceeds exceed their initial investment in the policy.

Example(s):  Consider a life insurance policy with the following values: cash value of $15,000, owner's basis of $14,000, and unrealized gain of $1,000. If you borrow $15,000 from your life insurance policy, the $1,000 unrealized gain will not be subject to taxation at this time. At the time of your demise, your insurance company will deduct any outstanding loan balance (plus interest) from the death benefit and pay your beneficiary the remainder tax-free. (The date the policy was issued is irrelevant for loans.)

• In many instances, you can withdraw and retain all or a portion of the cash value accumulation in your policy. This is known as a partial surrender, and it reduces the policy's cash surrender value and mortality benefit. A partial renunciation is generally taxed on a first-in, first-out (FIFO) basis. Consequently, only quantities received in excess of your basis will be taxed.
• Complete renunciation is the termination of an insurance policy. The insurance company will typically send you a check for the net cash surrender value at this time. The difference between the cash surrender value of the policy (plus any outstanding loans) and your basis in the contract is considered taxable income for tax purposes.

Death Proceeds

The proceeds from a life insurance policy paid upon the insured's demise are generally not included in the recipient's taxable income; they are received tax-free. Amounts payable upon the insured's death are excluded, regardless of whether they represent the return of premiums paid, an increase in the policy's value due to investments, or the funeral benefit feature. It makes no difference whether the life insurance proceeds are received in a single sum or in some other manner. (However, any interest paid in conjunction with the life insurance payout is generally taxable.)

Tip: Additionally, Caterpillar clients must be aware of the estate and gift tax implications of life insurance. In general, a policy's proceeds are included in the insured's estate if:

• The proceeds were payable to or for the benefit of the insured's estate; or the decedent transferred the policy for less than fair consideration (value) within three years of his or her demise; or 

• the proceeds were payable to or for the benefit of the insured's estate.
• At the time of death, the insured held all incidents of ownership, such as the right to alter the beneficiary.

The fair market value of your interest in a life insurance policy at the time of the gift may be subject to gift taxes if you give it away.

Dividends

A dividend is the quantity of your premium that is returned to you if your insurance company achieves a lower-than-expected mortality rate among policyholders. If you are a 55-75-year-old or older Caterpillar employee, you should be aware that life insurance dividends are typically regarded as a return on investment and are not considered taxable income to the policy owner. Unless they surpass the total cumulative premiums paid on the policy. It makes no difference whether dividends are received in cash, left with the insurance company to prepay premiums or accumulate, or received in some other form. Nonetheless, if you leave these dividends on deposit with your insurance company and they accrue interest, you must include the interest as taxable interest income. Generally speaking, life insurance premiums are not tax deductible.

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What About Modified Endowment Contracts?

The Internal Revenue Code (IRC) defines the modified endowment contract (MEC) as a special category of life insurance contract. MECs are subject to special tax regulations under the IRC. In general, loans and partial surrenders of MECs are subject to immediate taxation if the financial value of the contract exceeds the premiums paid. In addition, withdrawals and loans from a MEC prior to age 5912 may be subject to a 10% tax penalty.

What About Personal Life Insurance Trusts?

Sometimes it makes sense to transfer an existing life insurance policy into a trust or have the trust purchase a new life insurance policy. There are two categories of trusts: irrevocable and revocable. These two categories of trusts are taxed differently.

Irrevocable Life Insurance Trust

The primary advantage of this form of trust is that the proceeds from your life insurance policy will not be included in your estate for estate tax purposes after your death. This type of trust is frequently used if your assets will exceed the applicable exclusion amount at the time of your demise, or if you wish to control the timing of a beneficiary's distribution of funds. Caterpillar clients should also bear in mind that if their trust beneficiaries are granted 'Crummey powers,' their lifetime transfers of cash into the trust (to purchase a life insurance policy) may qualify for the annual gift tax exclusion.

Revocable Life Insurance Trust

The assets in a revocable life insurance trust must be included in the decedent's taxable estate. This could have negative estate tax implications. However, this form of trust can be useful if your beneficiaries are minor children and you wish to control the timing of the insurance proceeds' distribution.

Regarding Business Insurance, What Are Some of The Planning Vehicles?

Businesses frequently utilize a variety of insurance policies, and the tax treatment varies based on the form of policy. Life insurance in the form of group insurance, key employee coverage, split dollar, or corporate-owned policies may be utilized as an employee benefit and/or to achieve specific business objectives. Moreover, property, casualty, and liability insurance policies are utilized to protect against natural disasters and litigation. In addition, insurance can be utilized to finance retirement plans and buy-sell agreements. You may be concerned about both the deductibility of premiums and the taxation of proceeds if you are a business proprietor.

In general, no deduction is allowed for premiums potentially paid by a business like Caterpillar on any life insurance policy covering the life of any officer or employee of the employer, or of any person financially interested in any trade or business carried on by the employer, when the employer, like Caterpillar, is a direct or indirect beneficiary of the policy. Therefore, an organization cannot deduct insurance premiums used to finance buy-sell agreements and retirement plans. Additionally, our Caterpillar clients should be aware that the premiums paid by a business for critical employee coverage and split-dollar life policies are typically not tax deductible. Nonetheless, a business can typically deduct the cost of group life insurance it provides to its employees, as well as the cost of property, casualty, and liability insurance.

Despite the absence of a deduction for life insurance premiums, life insurance can be a useful instrument for many businesses. In most cases, life insurance proceeds are tax-free. In addition, the cash value accumulation on a life insurance policy is generally not taxed currently, although in certain circumstances this accumulation could subject the business to the alternative minimum tax (AMT). Typically, withdrawals and advances are treated favorably.

Withdrawals of cash value from a life insurance policy are generally first regarded as taxable distributions of earnings on the contract. Withdrawals in excess of the contract's earnings will be regarded as a nontaxable recovery of the contract's basis. In contrast, loans are not regarded as distributions. Consequently, they are not immediately subject to taxation. In some instances, policy loan interest may be tax deductible.

For business purposes, the deduction for casualty losses is regarded differently than for individual purposes. A casualty is, for tax purposes, a loss of property caused by a fire, storm, shipwreck, or other abrupt catastrophe that causes direct damage. Insofar as the quantity of money or property a business receives as reimbursement for a casualty loss is less than the property's adjusted basis, the business can deduct the entire difference. If the business chooses not to file a claim, no loss deduction will be allowed to the extent that such losses are covered by insurance.

How Can Tax Planning With Life Insurance Help You With Charitable Giving?

You may have a strong desire to support your favored or charities. At the same time, you may be concerned about leaving your family or other loved ones with sufficient assets. Using life insurance as part of your charitable giving strategy may enable you to achieve both of the aforementioned objectives and provide you with tax benefits.

Naming the Charity as Beneficiary

If you designate a charity as the beneficiary of your life insurance policy, the proceeds will not be included in your estate for tax purposes. Your estate will be eligible for a charitable deduction for estate tax purposes, but you will not be eligible for a deduction on your income tax return. This strategy is suitable for our Caterpillar clients who wish to retain access to the policy's cash surrender value during their lifetime, but donate the proceeds from the death benefit to charity.

Transferring Policy Ownership to Charity

You may also transfer ownership of your life insurance policy to a charity or pay the premiums on charity-owned life insurance policies. You may be eligible for a limited income tax deduction if you meet the requirements. The gift tax charitable deduction exempts from gift tax an explicit donation of a life insurance policy to a charity.

Gift of Cash Surrender Value

You cannot claim a charitable deduction on your gift tax return if you assign only the cash surrender value of the policy to a charity and retain the right to designate the beneficiary and assign the remainder of the policy.

Tip:  Life insurance can also be used in conjunction with charitable remainder trusts.

What is the difference between a partial surrender and a complete surrender of a life insurance policy in terms of tax implications?

A partial surrender of a life insurance policy refers to the withdrawal of a portion of the policy's cash value accumulation while leaving the policy in force. The amount withdrawn is generally taxed on a first-in, first-out (FIFO) basis, which means that only amounts received in excess of the policyholder's basis (the total amount of premiums paid) are subject to taxation.

In contrast, a complete surrender refers to the termination of the life insurance policy, in which the policyholder receives the net cash surrender value of the policy (cash surrender value minus any outstanding loans). The amount received in excess of the policyholder's basis is considered taxable income for tax purposes.

In summary, a partial surrender only withdraws a portion of the policy's cash value, while leaving the policy in force, and is taxed on a FIFO basis. A complete surrender terminates the policy and results in the policyholder receiving the net cash surrender value, which is taxable on the amount received in excess of the policyholder's basis.

Conclusion

Imagine you are a seasoned traveler, preparing to embark on a new journey to a foreign land. You've done your research and have an itinerary in place, but you're not quite sure what to expect when you arrive. Will the language barrier be a challenge? Will the customs and traditions be unfamiliar? Will you be able to navigate the terrain? Retirement can be a lot like traveling to a new place. It's an exciting adventure, but it can also be daunting and uncertain. You may have a plan in place, but there are still many unknowns. Will your savings be enough to sustain you? How will you adjust to a new routine and lifestyle? Will you be able to navigate the healthcare system? Just like when traveling to a foreign land, it's important to do your research and prepare ahead of time. Seek advice from those who have gone before you and learn from their experiences. Consider working with a financial advisor to help you plan and manage your retirement funds. And remember, just like when traveling, unexpected surprises and challenges may arise, but with careful planning and preparation, you can enjoy a successful and fulfilling retirement journey.