Foreign Life Insurance Policy Disposition

[GaryinOz2002]

Hi, I am a resident alien in U.S., born in Canada. I just (2022) cashed in two long-time Canadian life insurance policies, one a whole life policy bought by my father when I was a child (I am now 67 yo) and another a term policy I bought in the early 1980s.  For most of the years, I was able to use dividends spun off from the whole life policy to pay premiums for both policies, so I have not paid premiums for years. When I cashed in the two policies, I paid federal non-resident Canada tax (about $6800 CAN) and received, net, about $19K US.  Do I still pay U.S. taxes on this as Other Income or am I exempt?  I am guessing Canada has a treaty with US on taxes.  What IRS forms do I need to complete? Is there anyone I can consult for help on this?

[tagteam]

@pk

[GaryinOz2002]

Hello, did someone (tagteam?) answer my question?  What is the answer?  I can't seem to read it or open a message/post.

Thanks!

G.

[pk]

@GaryinOz2002 , can you give me a day to chew on this ?  Generally, foreign life insurances  are treated as  non-regulated investment companies and therefore Mar-to-Market rules apply.  But  because Canada and US have a much closer relationship , I need to go over the treaty a bit more  ( including the technical  explanations).

Will circle back by 12/29

pk

[GaryinOz2002]

Thanks, I appreciate your expertise on this issue.  My thoughts are that I would enter the money I received as "Other Income" or "Income from foreign sources" and have the life insurance accounts listed under foreign assets.  Since I paid foreign income tax already, I would go for a foreign tax credit, unless the taxes owed are insufficient to generate the credit. However, the alternative might be to reduce the money I received by the amount paid in foreign taxes and just list the net amount under "Other Income."  I read somewhere on this board where it is possible that little of this is actually earned income and that it is just my returned investment (minus any premium I may have paid over the years, if I still have the records...). But this means I might have to list how much actual income was generated over the years, which could be difficult/impossible to know.

Just a few of my thoughts. Thanks again for your help. BTW, what are Mar-to-Market rules?

Gary

[pk]

@GaryinOz2002 , as I mentioned earlier , most foreign life insurance schemes  are treated as Passive Foreign Investment Company ( PFIC) and therefore  one pays tax on the yearly gain (  a formulation based on  surrender value, contribution and value at death  ). There are ways around this but is quite expensive.

If I assume that you have been here in the USA for  number of years  and never reported / recognized  this  tax ( Mark-to-Market  approach ) this earning, and that you are currently have  or will soon liquidate/ surrender   the life insurance policies  and recognize the total amount   for these policies,  then the easiest  way to handle this is ( for each policy being liquidated :(

(a) prepare a spread sheet  that shows, year by year the amount of contribution to the policy, the surrender value for the year  and pay-out on death -- face value of the policy;  in the contributions also include any other required expenses / fees etc. that you had to pay.

( b ) Convert all these Canadian currency contributions  to US$ using the exchange rate prevalent at the time  ( IRS / Treasury publishes yearly average rate for all the past years  )

(c) At the end of this exercise what you should have  are two figures that you need --- total contribution in US$ and the total US$ you get at surrender.  The  difference between the two  is treated as  interest earning  { it is ordinary income and is the category where it fits nicely and suggested by the IRS ). 

(d) please keep the print-out of the  spread sheet for your records  in addition to the back-up details of the transactions  on the policy over the years ( to the extent  feasible -- your policy admin should be able to give you  this ).   These are essential  in case of an audit --- show that you followed a logical path  and based on back-up data. 

On the subject of foreign  taxes paid , generally  --- you use form 1116  to report the foreign income and the taxes paid thereon. However note that while IRS will recognize the total amount of taxes paid ( us$) but available for the year is limited  by a ratio of  foreign income  to world income . The un-used portion of the credit can be carried back  or carried forward-- but to avail it  you still need foreign income ( because the same ratiometric  limitation would be applied.   A safe harbor ( from the limitation  and therefore use of  form 1116 ) amount of US$ 300 per  taxpayer  is also available  ( i.e. US$600  per jointly filed return ).

An erroneous but sometimes used method is to subtract the  foreign tax from the  received amount  ( i.e. use the  net foreign income-- post foreign tax ). Depending on your total income from US sources ( assuming this liquidation is your only foreign income ), this  method  may not change the IRS take  enough to trigger audit.   If you are  going to use this method ( i.e. net of foreign taxes ), please work out both ways to make sure  that it is worth your while.

I did go through the  US-Canada treaty and the associated protocols  and  while there is carve out for Canadian pension plans , there is none for Life Insurance. So ...

I hope I have answered your query sufficiently.  Is there more I can do for you?

pk

[GaryinOz2002]

Hi, thanks so much for the really excellent and detailed explanation. I sent a request to the Canadian insurance company to see if they can send me the spreadsheet I need. 

One question: Are you suggesting that I NOT just report the total amount received, subtract the foreign taxes paid (as federal non-resident tax) and simply report the net amount as Other Income?  I get the sense this is not the preferred strategy, right?

Thanks again and Happy New Year!

Gary

[pk]

@GaryinOz2002 , preferred method of reporting / recognizing  the cash-out amount for US TAX PURPOSES ONLY is to  use the  Gross amount  ( the cash out value )  LESS the total of amounts  ( premiums etc. )  paid-in as the interest earned - not as "other income"  but interest earned .  This is also your Foreign Passive income  for purposes of form 1116.

Does this make sense ?

pk

[GaryinOz2002]

This is very helpful! One last question; what do I do for dividends that are reinvested within the policy to pay for the annual premiums? For many years I did not pay any premiums because both policies contributed dividends that paid for the premiums.

Thanks!

Gary

[GaryinOz2002]

Another quick question: The insurance company can provide the data on the policies, but only for the past seven years. Both policies were in effect for over 30 years.  Is it worth to pay them about $65 for getting the last seven years, and if I had these data, can I make use of this to report to the IRS?  Or is it better just considering the final pay out as other income and leave it at that?

Thanks again!

Gary

[pk]

@GaryinOz2002 , I don't know how to answer you ( for the fee being charged by the admin of the policy ).

May be an example would help  ( in this predicament ) and irrespective of when you cam into the USA and became a resident . --

Say  you got a life policy  with a face value  of US$20,000 and for 30 years you paid  a total of  US$5000 in premiums ( actually paid i.e. above and beyond  the re-invested dividends ).  For US tax purposes , if you declare the total received as  US$20,000 ( either as "other" or as interest/dividend " income :

(a) without the basis of  US$5000, you would be taxed at your ordinary income slab  on US$20,000

(b) if you instead claim the basis as US$5000 and a gross income of 20,000 , you would be taxed  on US$15,000 as ordinary income.  

Without the details of the  premiums levied/paid , you would not be able to withstand a  challenge  of the basis.

On the subject of re-invested dividends,  ideally  and atleast from the time you became a resident of the US  ( Green Card  or Resident for tax purposes ), you should have been reporting the dividends received/ declared and be taxed  on the income ( irrespective of whether  re-invested/ premium or expensed ).  At this stage it may be too late to go back and correct this  -- so I would take a chance , use the dividend as an offset to the premiums due.  I can stand an audit on this because  it is too late to update  and in the sum-total of taxes probably would not have a sufficient difference.

Does this make sense to you?

pk

[GaryinOz2002]

Thanks for this great answer. My initial question was really about whether it is worth it to ask for seven years' of statements when in fact the policies were held for much longer and thus I would not have a complete paper trail. I entered the US initially as a graduate student at Tufts (1985-89) then got a job and stayed. The term policy was probably bought in 1982, or thereabouts. The whole life policy was bought by my father when I was probably 4 or 5 years old, say 1959-60 roughly. My father paid the premium on the whole life until probably when I was in college or even beyond, so let's say I started paying premiums roughly in 1979-80 on that policy and they were only about 425CAD, but probably by the time I bought the term policy, I had them both on automatic pilot and each year the dividends spun off from the policies paid the dividends with the rest, if any, accrued as added value to the policies. Over the years the insurance company (originally London Life, now Canada Life) changed their procedures for allowing premiums to be paid from accrued dividends and so on various years, probably most likely in the 90's and 00's, I paid the annual premiums to maintain the policies, but most of the time I was able to draw on the dividends to pay it.  The premiums on both policies were not expensive, probably 400-500CAD each per year. I probably have records from Quicken for the past 20 years but I guess it would be good to know if they were accurate if I were to get the last seven years of information directly from the insurance company, and, more importantly, they would tell me the change in value of each policy each year, which I would not have in my records.

I turned over both policies this past September, and, after paying Canadian federal non-resident tax, and with the exchange rate, I netted $19,300 US total.  Obviously, I do not want to get in trouble if audited, and I want the easiest way to have records available if I am.  Can you tell me whether I should use the last seven years' data, that is, would this be useful, or just go with the final net money sent to me (the $19,300 US). Should I call this Other Income or as you suggest, and sorry if I get this wrong, that I can use the occasional premium payments I did pay and/or the dividends to offset some of the final value I received as income.

I really appreciate the time, attention and expertise you are putting towards this and I promise I will not keep asking questions.

Thanks!

Gary

[DaveF1006]

It depends. In this instance, you should try to determine how much of the cash surrender is premium and how much is earnings from interest or dividends.  Any earnings over and above the premiums paid is taxable income. The last 7 years of statements may be helpful but it is difficult to say. Keep in mind, any dividend that is reinvested as a premiums is taxable. Only the premiums paid out of your own pocket are non taxable.

Regardless, you would report this as other income on your return. here is how to report.

1. Click Federal Taxes -> Wages & Income and scroll down to Less Common Income
2. Go to the last selection, Miscellaneous Income and click Start
3. Go to the last option, Other reportable income and click Start
4. When it asks, "Any other reportable income?" say yes and then type in a description and the amount to report it on your tax return.

@GaryinOz2002

[pk]

@DaveF1006 , I stand corrected  in that foreign life insurance income proceeds ( cashing out amount less amounts paid  ) should be reported as "other income on Schedule-1, line 1z.   I had stated  that this should be treated  as  interest/dividend  income ( think that was the earlier  guidance but in 2022 tax year it is clearly stipulated -- enough  for  even my blind eyes ).  Thank you

I recognize the  resultant  tax is the same no matter how yo declare it -- passive  & ordinary income.

[valleybuy]

@pk 

I have the exact scenario. i have Indian  life insurance pension fund bought 20 years back , paid premium only beginning 5 years and it’s maturing next year.

I want to get rid of it so have options to encash the surrender value (grown 5 times) or postpone the maturity or convert to annuity that pays rest of life.

question if I surrender this pension fund is this classified as PFIC form 8621 and hence need to do 1291 excess distributions (highest taxable tax)

I assume pension funds are exempt from PFIC

if not then should I follow the same method above of reporting net of surrender cash value and USD converted premium as other income in 8938 and pay ordinary income tax?