Rev. Rul. 68-648

The Internal Revenue Service has been asked whether an employee's election of an extended term life insurance option available under a retirement income contract, purchased for him by an organization exempt from tax under section 501(c)(3) of the Internal Revenue Code of 1954, will cause the accumulated policy reserve to be included in the employee's gross income in the taxable year the option is elected.

An organization exempt from Federal income tax under section 501(c)(3) of the Code, purchased for one of its employees a retirement income contract that met the requirements of section 403(b) of the Code. In addition to certain other settlement options, the contract provided that, upon the termination of his employment, the employee could elect to receive the accumulated policy reserve in a single lump-sum distribution or to have the accumulated policy reserve applied to provide extended term life insurance. The employee was subsequently disabled and terminated his employment. He was unable to assume the premium payments for the contract and therefore elected the extended term life insurance option available thereunder. The accumulated policy reserve was used as a single premium payment for this term insurance. The election of this option extinguished the employee's right to any retirement or annuity payments.

Section 403(b) of the Code provides that certain amounts contributed by an employer, exempt from Federal income tax under section 501(c)(3), to purchase an annuity contract shall be excluded from the gross income of the employee for the taxable year if the conditions set forth therein are met. However, the employee shall include in his gross income the amounts received under such contract for the year received as provided in section 72 of the Code (relating to annuities).

Section 1.72-11(d)(1) of the Income Tax Regulations provides that any amount received upon the surrender, redemption, or maturity of a contract to which section 72 of the Code applies, which is not received as an annuity, shall be included in the gross income of the recipient to the extent that it, when added to the amounts previously received under the contract and which were excludable from the gross income of the recipient under the law applicable at the time of receipt, exceeds the aggregate of the premiums or other consideration paid. See section 72(e)(2)(B) of the Code.

The election of the extended term life insurance option was equivalent to the receipt of the accumulated policy reserve by the employee and the subsequent purchase of term life insurance covering a prescribed period. Thus, there has been a redemption of the retirement income contract within the meaning of section 72(e)(2)(B) of the Code.

Accordingly, the accumulated policy reserve applied to the purchase of the extended term life insurance will be taxable under section 72 of the Code in the taxable year the option is exercised.