How Are Gains in VUL Sub-Accounts Taxed on Transfer?

A Variable Universal Life (VUL) policy is a form of permanent life insurance that includes a cash value component alongside a death benefit. The premiums paid are divided, with one portion covering the cost of insurance and fees, and the remainder being deposited into the policy’s cash value. This cash value is directed by the policyholder into various investment options, known as sub-accounts, which function much like a family of mutual funds and expose the cash value to market risk and potential growth.

The structure of a VUL allows for flexibility in premium payments and can be adjusted to meet changing financial goals. Policyholders can allocate their cash value among an array of stock, bond, and money market sub-accounts, tailoring their investment strategy to their personal risk tolerance. The central question for many policyholders revolves around the tax implications of managing these investments, specifically what happens when they decide to move accumulated funds from one sub-account to another within the policy.

The Principle of Tax-Deferred Growth in VUL Policies

A primary feature of a VUL policy is the tax-deferred growth of its cash value. This means that as the investments within the sub-accounts generate returns, those gains are not subject to annual income taxes. This tax treatment is codified under Internal Revenue Code Section 7702, which sets the criteria a policy must meet to qualify for these tax advantages.

This tax deferral is often referred to as the “insurance wrapper” benefit. It allows the cash value to compound more efficiently over time than it might in a taxable brokerage account, where annual gains would be taxed.

To maintain this tax-advantaged status, a VUL policy must satisfy one of two tests under the tax code: the Guideline Premium and Cash Value Corridor Test or the Cash Value Accumulation Test. These tests ensure that the policy functions primarily as life insurance rather than a pure investment vehicle. The death benefit paid to beneficiaries is also generally received income tax-free.

Tax Treatment of Internal Sub-Account Transfers

When a policyholder moves funds from one sub-account to another within the same VUL policy, this action is not a taxable event. For example, if a policyholder reallocates $10,000 in gains from a stock-based sub-account to a bond-based sub-account, no income tax is due on that gain at the time of the transfer. The gains are not considered “realized” for tax purposes because they have not been withdrawn from the policy itself.

The transfer is merely a reallocation of assets within the investment component of the policy, not a distribution to the policyholder. This allows individuals to adjust their investment strategy in response to market conditions or changes in their financial objectives without triggering a tax liability.

While these internal transfers are tax-free, some insurance companies may impose contractual limitations or fees. For instance, a policy might limit the number of free transfers allowed per year, with subsequent transfers incurring a nominal administrative fee. These fees are a matter of contract terms and are separate from the tax treatment of the transaction.

Actions Triggering Taxation in a VUL Policy

While internal transfers are not taxable, certain other actions can result in a tax liability for the owner of a VUL policy that is not classified as a Modified Endowment Contract. The tax treatment of distributions is governed by a “First-In, First-Out” (FIFO) basis. This means that withdrawals are first considered a return of the premiums paid into the policy (the cost basis) and are therefore received tax-free. Only after the entire cost basis has been withdrawn do further distributions become taxable as ordinary income.

Policy loans are not considered taxable distributions. However, a loan can become taxable if the policy lapses or is surrendered while the loan is outstanding. In such a scenario, the outstanding loan balance, including any accrued interest, is treated as a distribution. If this amount exceeds the policy’s cost basis, the excess is subject to income tax.

The full surrender of a policy for its cash value is a taxable event. If a policyholder decides to terminate their contract and receive the accumulated cash surrender value, they must recognize any gain as ordinary income. The taxable gain is calculated as the total cash value received minus the policy’s cost basis.

Impact of Modified Endowment Contract Status

The standard tax rules for VUL policies change if the policy is classified as a Modified Endowment Contract (MEC). A life insurance policy becomes a MEC if it fails the “7-pay test,” which occurs when the cumulative premiums paid into the policy at any time during the first seven years exceed the total of the net level premiums that would have been needed to pay up the policy in seven years. This test was established by the Technical and Miscellaneous Revenue Act of 1988 to prevent the use of life insurance as a tax-sheltered, short-term investment vehicle.

Once a policy is classified as a MEC, its tax treatment for distributions is permanently altered. Instead of the FIFO method, distributions from a MEC are taxed on a “Last-In, First-Out” (LIFO) basis. This means that any gains or earnings within the policy are considered to be withdrawn first, before the return of the cost basis.

In addition to LIFO tax treatment, distributions from a MEC may be subject to a 10% penalty tax. This penalty applies to the taxable portion of any distribution, including loans, taken before the policyholder reaches age 59½. This penalty is similar to the one imposed on early withdrawals from qualified retirement plans like a 401(k) or an IRA.