Chapter 5- Federal Tax Considerations for Life Insurance and Annuities
Direct Rollover
20% can be avoided if the distribution is made directly from the first plan to the trustee of the new IRA plan
Incidents of ownership, estate as beneficiary, transfer of ownership
3 situations that will result in life insurance being included in the insured's taxable estate:
nontaxable exchange
A 1035 exchange is a ___________ of cash value life insurance or an annuity on the same life
Rollover
A tax-free distribution of cash from one retirement plan to another Must be completed within 60 days from the time the money is taken out If the distributions is paid directly to the participant, 20% of the distribution must be withheld by the payor
Interest taxable
Accumulations are _____
Cash Value
Accumulations in the policy can be borrowed against by the policyowner, or may be paid to the policyowner upon surrender of the policy Grows tax deferred Upon surrender or endowment, any cash value in excess of the premium payments (cost basis) is taxable as ordinary income
7-pay test
All life insurance policies are subject to the ______, and any time there is a material change to a policy (such as increase to death benefit) a new 7-pay test is required
Spouse
An applicant buys a nonqualified annuity, but dies before the starting date. For which of the following beneficiaries would the interest accumulated in the annuity NOT be taxable? Charitable organization Dependents Annuitant Spouse
Endowment Policy
An investment instrument Promise to pay the face amount if the insured survives until the end of a specified period Require premiums far in excess of the amount required to fund the death benefit
Policy Loan Repayment
By the owner while the policy is in force At policy surrender or maturity, subtracted from the cash value At the insured's death, subtracted from the death benefit
Taxed at surrender
Cash Value Gains are _____
Not taxable (as long as policy in force)
Cash Value Increases is ______
One-Sum Cash Surrenders
Cash surrender of an annuity results in immediate taxation of the interest earned
Taxable at surrender
Cash value exceeding premiums paid are ______
Traditional IRA
Contribute 100% of income up to an IRS limit Excess contribution penalty is 6% Grows tax deferred Pre-tax dollars 10% penalty for early nonqualified distributions prior to 59 ½ Payouts must being by age 73
Roth IRA
Contribute 100% of income up to an IRS limit Excess contribution penalty is 6% Grows tax free (if open for 5 years) After-tax dollars Qualified distribution cannot occur until account open for 5 years and owner is 59 ½ No required minimum age for payouts
Modified Endowment Contract (MEC)
Cumulative premiums during the first 7 years exceed the total amount of net level premiums that would be required to pay the policy up Overfunded life insurance policy, failed the 7-pay test Once an MEC, always an MEC
Not income taxable (except for interest)
Death Benefit is____
Settlement Options
Death benefit spread evenly over income period Interest payments in excess of death benefit portion are taxable
Incidents of ownership
Defined as any one of the rights of policy ownership, such as the right to cash value, the right to change the beneficiary, the right to obtain policy loans, or the right to assign the policy If the policyowner possessed any one of these incidents of ownership at the time of their death, the entire face amount of the policy will be included in the insured's taxable estate
Taxable in the year earned
Dividend interest is ____
Not taxable
Dividends are _____
Section 1035 Exchange
Exchanges of life insurance policies and annuities may occur as nontaxable exchanges When a policyowner exchanges a cash value life insurance policy for another cash value life insurance policy, or a cash value life policy for an annuity or an annuity for an annuity, the policies or annuities must be on the same life, no income tax
tax advantages
Following the the Tax Reform Act of 1984, single premium life insurance remained as one of the few financial products offering significant ______
Corporate Owned
Growth in the annuity is not tax deferred Interest income is taxed annually unless the corporation owns a group annuity for its employees, and each employee receives a certificate of participation
Accumulated cash value
If an annuitant dies during the accumulation period, what benefit (if any) will be included in the annuitant's estate? Accumulated cash value Full annuity benefit No benefits Policy loans
Settlement option.
If an immediate annuity is purchased with the face amount at death or with the cash value at surrender, this would be considered a Nonforfeiture option. Rollover. Settlement option. Nontaxable exchange.
Premature Distributions
If money is withdrawn before 59 ½ there is a 10% tax penalty
deceased annuitants estate
If the annuitant died during the accumulation period, the insurer is obligated to return all or a portion of the annuity cash value which will be included in the _______
Distributions at Death
If the annuity contract holder dies before the annuitization date, the interest accumulated in the annuity becomes taxable If the beneficiary is a spouse, the tax can continue to be deferred
Surrenders
If the cash surrender value exceeds the amount of premiums paid then it will be taxable as income When the owner withdraws cash value from a universal life policy (partial surrender) both the cash value and the death benefit are reduced by the surrender
Estate Tax
If the insured owns the policy, it will be included for estate tax purposes If the policy is given away, and the insured dies within 3 years of the gift, the death benefit will be included in the estate
Estate as Beneficiary
If the insured's estate is the designated beneficiary at the time of the insured's death, the entire face amount of the policy will be included in there taxable estate
Transfer of Ownership
If the insured, as policyowner, assigns or transfers ownership of the policy or makes a gift of the policy within 3 years prior to their death, the entire face amount of the policy will be included in their taxable estate
December 31 of the calendar year of the 5th anniversary
If the owner dies before distributions have begun, the entire interest must be distributed in full on or before ___________ of the owner's death, unless the owner named a beneficiary
From trustee to trustee
In a direct transfer, how is money transferred from one retirement plan to a traditional IRA? From trustee to the participant From the participant to the new plan From the original plan to the original custodian From trustee to trustee
interest
In settlement options, the principal is tax free but the _____ is taxable
10
Individual beneficiaries other than a spouse must withdraw the entire amount from the account within ___ years of the account owner's death
The entire face value of the policy will be included in J's taxable estate.
J transferred his life insurance policy to his son two years before his death. Which of the following is true? The interest portion of the policy will be included in J's taxable estate. The unpaid premiums on the policy will be deducted from J's taxable estate. Because the policy has been transferred, it will not be included in J's taxable estate. The entire face value of the policy will be included in J's taxable estate.
Amount Received by Beneficiary
Life insurance proceeds paid to a named beneficiary are generally free of federal income taxation if take as a lump sum Exception would be if the benefit payment result from a transfer for value (sold to another party before insured's death)
tax free
Lump sum cash payment of life policy proceeds are _____ for the beneficiary
Not income taxable
Lump-sum death benefit is _____
Cost Base
Nontaxable portion of annuity Anticipated return of the principal paid in
Roth IRA Distributions
Not included in taxable income Qualified distributions cannot be made prior to the 5th year of the account's existence Qualified distributions include those made after 59 ½, those made to the estate or beneficiary, those made to the disabled owner, first time home buyer, or if paying for higher education Qualified distributions have no 10% tax penalty
Roth IRAs Tax
Not tax deductible Excess contributions are subject to a 6% penalty
FIFO
Partial Surrenders
Conditions where 10% penalty would not apply
Participant is over 59 ½ Participant is fully disabled Money is used to make a downpayment on a home Withdrawals are for post-secondary education Withdrawals are for catastrophic medical expenses, or upon death
Accumulation Phase
Period after an annuity has been purchased but before distribution begins Taxes are deferred If money is withdrawn in this face, taxed on a LIFO basis Money withdrawn is taxed until cost basis is met After all interest is received and taxed, the principal will be received with no additional tax consequences
Not taxable
Policy dividends are _____
Not income taxable
Policy loans are ______
Not income taxable
Policy loans are____
Policy Loans
Policyowner may borrow against the policy's cash value Not income taxable Company charges interest on outstanding loans
Individually-Owned Annuity
Portion of each benefit payment is taxable Nontaxable portion = anticipated return of the principal paid in (cost base) Portion that is taxable is the interest earned on the principal (tax base)
Tax Base
Portion that is taxable of annuity Interest earned on the principal
Not deductible (personal expense)
Premiums are _____
Not tax deductible
Premiums are _______
Life Insurance
Premiums are not taxable Death benefit: Tax free if taken as a lumps-sum Principal is tax free; interest is taxable if paid in installments
Cost Basis
Principal amount Amount that was paid into the annuity Excluded from taxes
Transfer
Refers to a tax-free transfer of funds from one retirement program to a traditional IRA or a transfer of interest in a traditional IRA from one trustee directly to another
Dividends
Return of unused premium Not considered income for tax purposes Interest earned on dividends are subject to taxation as ordinary income
Tax rules for Traditional IRA
Tax-deductible contributions for the year of the contribution Contributions must be made in "cash" in order to be tax deductible Excess contributions are taxed at 6% per year as long as the excess amounts remain in the IRA Tax-deferred earnings are not taxed until withdrawn Distribution prior to 59 ½ = 10% penalty
Taxation rules that apply to MEC's cash value
Tax-deferred accumulations Any distributions are taxable, including withdrawals and policy loans Distributions are taxed on LIFO basis- "interest-first" rule Distributions before age 59 ½ are subject to a 10% penalty
contribution/ distribution
Taxes must be paid either upon ______ or ______, NOT both
Seven-Pay Test
To determine if an insurance policy is over funded Any life insurance policy that fails this test is classified as a Modified Endowment Contract (MEC) and loses the standard tax benefits
Owner's income
Traditional IRA contributions are tax deductible based on which of the following? How long the plan has been in force Owner's age IRA limit Owner's income
taxable/ NOT taxable
Traditional IRA distributions are _____, Roth IRA distributions are ________
Spouses who are the beneficiary
Treat an IRA as their own Base the required minimum distribution (RMD) on their current age Base the RMD on the decedent age at death Withdraw the entire account balance by the end of the 5th year following the account owner's death Spouse can wait until the owner would have turned 73 to being received RMD
Exclusion Ratio
Used to determine the annuity amounts to be excluded from taxes
It determines if the insurance policy is a MEC.
What is the main purpose of the Seven-pay Test? It requires level premium payments for 7 years. It ensures that the policy benefits are paid out in 7 years. It guarantees the minimum interest. It determines if the insurance policy is a MEC.
Benefit Payment
When an annuity is used to fund a traditional IRA, distributions are fully taxable if contributions were made with pretax dollars If there are no distributions at the required age, or if the distributions are not large enough, there is a 25% penalty
Settlement options
When the beneficiary receives payments consisting of both principal and interest, the interest portion of the payments received is taxable as income
tax free
Whether from a life insurance policy or a MEC, the death benefit received by the beneficiary is ____
Withdrawn amounts are taxed on a last in, first out basis.
Which of the following describes the taxation of an annuity when money is withdrawn during the accumulation phase? Withdrawn amounts are taxed on a last in, first out basis. Withdrawn amounts are taxed on a first in, last out basis. Taxes are deferred on withdrawn amounts, but a flat penalty is charged. Taxes are deferred on withdrawn amounts.
A whole life insurance policy is exchanged for a term insurance policy.
Which of the following is NOT an allowable 1035 exchange? A whole life insurance policy is exchanged for a term insurance policy. A whole life insurance policy is exchanged for a Universal life insurance policy. An annuity is exchanged for another annuity. A life insurance policy is exchanged for an annuity.
Money borrowed from the cash value is taxable.
Which of the following is NOT true regarding policy loans? Policy loans can be repaid at death. An insurer can charge interest on outstanding policy loans. A policy loan may be repaid after the policy is surrendered. Money borrowed from the cash value is taxable.
