Specific tax rules are identified with particular codes. That’s why the tax rules are defined as tax codes. One of the most commonly looked-up tax codes of the Internal Revenue Service is Section 7702.
IRS Section 7702 defines what the government thinks of a valid life insurance policy and how taxes affect the proceeds. Section 7702 clearly outlines the tax advantages of the death benefit those covered under the life insurance policy. The death benefit paid to the beneficiary and any gains paid regularly for their life isn’t taxed.
While not paying taxes on death benefits sound great and all, it’s also a vulnerable part of the US tax code. To prevent people from taking advantage of this unlawfully, there are requirements to weed out policies that aren’t genuine.
There are two main requirements, also known as tests, that every life insurance policy must meet to not be seen as an investment tool.
Premium test
The guideline and corridor premium test require the policyholder to not pay more to the policy than the necessary amount to fund the benefits. This must happen for the total duration. At any time the premiums paid exceed the amount required to fund the benefits, the IRS will consider the death benefit as ordinary income and tax as such.
Cash value accumulation test
Similar to the guideline and corridor premium test, the cash value accumulation test conditions that the cash value surrender value of the policy must not exceed the single premiums paid to fund future benefits. In other words, the amount you pay opt-out from the policy can’t be more than what you have paid to obtain it.
If a life insurance policy doesn’t meet either one of these requirements, the death benefits received are going to be subject to federal income taxes as the IRS will consider them as ordinary income.