Taxes are a major reason people buy life insurance, annuities, and employer benefits, so the exam tests the federal rules in detail. This guide covers how life insurance premiums, cash values, loans and death benefits are taxed; modified endowment contracts; 1035 exchanges; business-owned insurance; estate and gift tax; qualified retirement plans; and the taxation of health, disability, HSA and long-term care coverage. Dollar limits that change each year are given as 2026 figures. These are federal rules; state income tax rules are not covered here.

Life insurance: the general picture

• Premiums for personal life insurance are not deductible.
• Cash value growth is tax-deferred while it stays in the policy (IRC 7702).
• Death benefits paid to a named beneficiary are generally income-tax-free (IRC 101(a)). If proceeds are left with the insurer under a settlement option, the interest is taxable.
• Policy dividends are a return of premium and are not taxable until total dividends exceed premiums paid. Interest on dividends left to accumulate is taxable in the year credited.
• Withdrawals from a policy that is not a MEC are taxed FIFO: the cost basis comes out first, tax-free.
• Loans from a non-MEC policy are debt, not income, and aren't taxed while the policy stays in force. If the policy lapses or is surrendered with a loan larger than basis, the excess is taxable even though no cash is received.
• Surrender – any amount above the cost basis (premiums paid, less tax-free withdrawals and dividends) is ordinary income. Example: $55,000 surrender value − $40,000 basis = $15,000 taxable.
• Accelerated death benefits paid to a terminally ill insured (expected to die within 24 months) are treated as death benefits and excluded from income; chronically ill insureds get the same treatment within limits (IRC 101(g)).
• Life settlements – when a healthy insured sells a policy, the gain up to the inside buildup is ordinary income and any excess over cash value is capital gain (Rev. Rul. 2020-5).

Transfer-for-value rule

If a policy is sold or transferred for valuable consideration, the death benefit above the buyer's basis (price paid plus later premiums) becomes taxable. Exceptions (IRC 101(a)(2)(B)): transfers to the insured, the insured's partner, a partnership in which the insured is a partner, or a corporation in which the insured is a shareholder or officer.

Modified endowment contracts (MECs)

A policy that fails the 7-pay test (cumulative premiums in the first seven years exceed the net level premiums needed to pay the policy up in seven years) is a MEC (IRC 7702A).

• The death benefit stays income-tax-free.
• Loans and withdrawals are taxed gain first (LIFO), with a 10% additional tax on the taxable amount before age 59½ unless an exception applies.
• Once a MEC, always a MEC, and a 1035 exchange of a MEC produces another MEC.
• Single-premium whole life is almost always a MEC.

Section 1035 exchanges

IRC 1035 lets an owner exchange one contract for another without recognizing the gain. Allowed:

• Life → life
• Life → annuity
• Annuity → annuity
• Life or annuity → qualified long-term care contract

Not allowed: annuity → life, because it would convert taxable deferred gain into tax-free death proceeds. A life-to-life exchange must involve the same insured, and any cash received (boot) is taxable.

Business-owned life insurance

• Key person and buy-sell premiums are not deductible when the business is a beneficiary (IRC 264); proceeds are generally income-tax-free.
• Employer-owned life insurance issued after August 17, 2006 keeps its tax-free death benefit only if the employer gave the employee written notice and obtained written consent before issue, and an exception applies, such as insuring a highly compensated employee (IRC 101(j)).
• Section 162 executive bonus – the employer pays the premium on a policy the employee owns; the bonus is deductible to the employer and taxable to the employee.
• Group term life (Section 79) – the cost of the first $50,000 of employer-paid coverage is tax-free; the cost of coverage above that is imputed income using IRS Table I rates. With $150,000 of coverage, the employee is taxed on the cost of $100,000. Group term premiums are deductible to the employer when the employer is not a beneficiary.

Estate and gift tax

• Life insurance proceeds are included in the insured's gross estate if the insured held any incident of ownership at death (right to change beneficiaries, borrow, surrender) or the proceeds are payable to the estate (IRC 2042).
• Three-year rule – a policy the insured gives away within 3 years of death is pulled back into the estate (IRC 2035).
• An irrevocable life insurance trust (ILIT) owns the policy so the insured holds no incidents of ownership.
• The unlimited marital deduction lets assets pass to a surviving U.S. citizen spouse free of estate tax (IRC 2056), which is why survivorship policies pay at the second death.
• 2026 figures: the annual gift tax exclusion is $19,000 per recipient, and the basic exclusion amount for estate and gift tax is $15 million per individual (Rev. Proc. 2025-32; Pub. L. 119-21).

Annuities

• Earnings grow tax-deferred; nonqualified withdrawals are taxed earnings first as ordinary income, with a 10% additional tax before 59½ (exceptions include death, disability, and substantially equal periodic payments).
• At annuitization, the exclusion ratio (investment ÷ expected return) sets the tax-free portion of each payment until basis is recovered; after that, payments are fully taxable.
• Gain paid at the owner's death is taxable to the beneficiary; there is no step-up in basis.

Qualified retirement plans

A qualified plan meets IRC 401(a) rules (nondiscrimination, participation, vesting, limits) in exchange for tax benefits: employer contributions are deductible, earnings grow tax-deferred, and distributions of pre-tax money are fully taxable as ordinary income.

2026 limits (IRS Notice 2025-67):

• IRA: $7,500, plus a $1,100 catch-up at 50+ ($8,600 total).
• 401(k)/403(b)/governmental 457 deferral: $24,500, plus an $8,000 catch-up at 50+, or $11,250 for ages 60-63.
• SIMPLE deferral: $17,000.

Other rules:

• Early distributions before 59½ are taxable plus a 10% additional tax unless an exception applies (IRA exceptions include up to $10,000 lifetime for a first home, higher education, and disability).
• Required minimum distributions begin at age 73 for people born 1951-1959 and 75 for those born 1960 or later (SECURE 2.0). The penalty for a missed RMD is 25% of the shortfall, or 10% if corrected promptly.
• Rollovers – an indirect rollover must be completed within 60 days, only one IRA-to-IRA indirect rollover is allowed per 12 months, and a plan distribution paid to the participant has 20% mandatory withholding. Direct trustee-to-trustee transfers avoid both.
• Inherited IRAs – most non-spouse beneficiaries must empty the account by the end of the 10th year after the owner's death.
• Vesting – employee contributions are always 100% vested; employer contributions in defined contribution plans must vest at least as fast as 3-year cliff or 2-to-6-year graded.
• Nonqualified deferred compensation may favor selected executives; the employer deducts benefits when the employee includes them in income.

Health insurance

• Employer-paid group medical premiums are deductible to the employer and not taxable to employees (IRC 106); medical benefits received are excluded from income (IRC 105(b)).
• Individuals who aren't self-employed may deduct health premiums and unreimbursed medical expenses only as itemized deductions above 7.5% of AGI.
• Self-employed people may deduct 100% of health premiums for themselves and their families as an adjustment to income, limited to net self-employment earnings, but not for months they were eligible for an employer-subsidized plan.
• Benefits from personally owned medical, AD&D, and critical illness policies are generally received tax-free.
• Section 125 cafeteria plans let employees pay their share of premiums and other qualified benefits pre-tax.

HSAs, FSAs, and HRAs (2026 figures)

• HSA – requires coverage under an HSA-qualified high-deductible health plan (minimum deductible $1,700 self-only / $3,400 family; out-of-pocket maximum $8,500 / $17,000) or, starting in 2026, an exchange bronze or catastrophic plan. Contribution limits: $4,400 self-only, $8,750 family, plus a $1,000 catch-up at 55+. Contributions are deductible (or pre-tax), growth is tax-deferred, and qualified withdrawals are tax-free. Nonqualified withdrawals before 65 are taxable plus 20%; after 65, only income tax applies. Medicare enrollment ends contribution eligibility. The account belongs to the individual and rolls over.
• Health FSA – pre-tax salary reductions up to $3,400; use-it-or-lose-it, softened by either a carryover (up to $680) or a 2.5-month grace period, not both.
• HRA – funded solely by the employer; plan design decides whether balances carry forward. A QSEHRA may reimburse up to $6,450 self-only / $13,100 family.
• Dependent care assistance – up to $7,500 excluded for a married couple filing jointly, starting in 2026.

Disability income

Personal disability premiums are not medical expenses.

Long-term care

• A tax-qualified LTC policy (IRC 7702B) is treated as accident and health insurance: employer-paid premiums are deductible and excluded from the employee's income, but LTC may not be offered through a cafeteria plan.
• Individuals may count qualified LTC premiums as medical expenses up to age-based limits. 2026 limits: $500 (40 or under), $930 (41-50), $1,860 (51-60), $4,960 (61-70), $6,200 (over 70).
• Benefits are generally tax-free; per diem benefits above $430 a day in 2026 may be taxable unless they don't exceed actual qualified costs.

Common exam traps

• Death benefits are income-tax-free; interest on held proceeds is not.
• Non-MEC withdrawals are FIFO; MEC and annuity withdrawals are LIFO.
• Annuity → life is not a 1035 exchange.
• Transfer for value taxes the death benefit unless an exception applies.
• Incidents of ownership or a gift within 3 years puts proceeds in the estate.
• Group term: first $50,000 tax-free; the cost above it is imputed income.
• Disability benefits are taxable when the employer paid the premium tax-free; tax-free when the individual paid with after-tax dollars.
• HSA: 20% additional tax before 65 for nonqualified use; no contributions after Medicare enrollment.
• Use the 2026 figures; they change every year.

Quick recap

• Life premiums aren't deductible; cash value is tax-deferred; death benefits are tax-free; loans and FIFO withdrawals from non-MECs aren't taxed until they exceed basis.
• MECs fail the 7-pay test and are taxed LIFO with a 10% additional tax before 59½.
• 1035 exchanges defer gain (but not annuity → life); transfer for value can make proceeds taxable.
• Estate inclusion turns on incidents of ownership and the 3-year rule; 2026 figures are a $19,000 gift exclusion and $15 million basic exclusion.
• Qualified plans are funded pre-tax and fully taxable on distribution; know the 2026 limits and RMD ages.
• Health premiums are tax-favored at work; HSAs are triple tax-advantaged; disability benefit taxation follows who paid the premium; qualified LTC is treated as health insurance.