Chapter 7: Federal Tax Considerations & Retirement Plans

Estate Taxes & Benefits

- Benefits may be included in the insured's estate, either intentionally or by default. - The policyowner may name the estate as a beneficiary, or by default, if no beneficiary is living at the time of the insured's death, the benefit will automatically be paid into the insured's estate. - These values will be added to the amount in the estate and potentially be subject to federal estate taxes. - If the policyowner is also the named insured, the proceeds will be added to the value of the insured's estate. - It is usually recommended to name an owner other than the insured for this reason.

Death Benefit Proceeds

- Death benefit proceeds from a group life insurance plan to an employee's named beneficiary are received income tax-free.

An IRA Owner May Take an Early Withdrawal Without Penalty for Certain Qualifying Events, such as:

- Death or permanent disability. - Up to $10,000 for the down payment on a home as a first time home buyer. - Medical expenses not covered or reimbursed by health insurance, or to pay health premiums. - Qualified educational expenses.

Non-Qualified Plans

- Do not meet requirements of federal law to be eligible for favorable tax treatment. - Because of this, contributions to a nonqualified plan are not tax deductible. - In many cases, such as a nonqualified annuity, the earnings are still tax deferred until withdrawn. - Upon withdrawal, only the earnings are taxable.

Estate Taxation

- During the accumulation phase, if the contract owner dies, the value of the annuity is included in the owner's estate for valuation. - If the annuitant dies during the annuity payout phase, the remaining value in the account will be added to the deceased annuitant's estate for valuation. - However, if the annuitant was receiving income from a Pure or Straight Life annuity, the company keeps the balance, and nothing goes into the annuitant's estate for valuation.

Premiums

- For individuals, premiums are considered a personal expense and are not deductible. - They are paid with after-tax dollars. - This establishes a cost basis in the policy for tax purposes.

Premiums Paid by the Employer and the Employee

- Group Term Life premiums paid by an employer are tax deductible to the business as an ordinary and necessary business expense. - Any employee paid premiums are not eligible for a tax deduction. - Employer paid premiums in connection with group life insurance do not constitute taxable income to the employee, unless the death benefit paid for by the employer exceeds $50,000. - All employer paid premiums for amounts above $50,000 are reported as taxable income to the employee.

Rollover

- f the payment is made directly to the IRA owner, they will have 60 days to deposit the check into a new IRA to avoid taxes and penalties. - This type of transaction is reported to the IRS and is only allowed once per year. - A 20% withholding of funds is required unless a direct rollover occurs. - A direct rollover applies when the funds are transferred from one qualified plan to the trustee of an IRA or another plan. - While this is reportable, the income is not taxable, and therefore no 60-day requirement applies.

Taxation

- If a contract is deemed to be a MEC, then any funds that are distributed are subject to a Last In, First Out (LIFO) tax treatment, rather than the normal First In, First Out tax treatment. - Taxable distributions include partial withdrawals, cash value surrenders, and policy loans (including automatic premium loans).

Policy Loans

- If a policyowner takes out a loan against the cash value of a life insurance policy, the amount of the loan is not taxable. - This is true even if the loan is larger than the amount of the premiums paid in. - The loan is not taxed as long as the policy is in force. - If the policy lapses with a loan outstanding, the excess over cost basis becomes taxable as ordinary income. - The interest paid on a permanent life insurance policy loan is not tax deductible.

Penalties

- If the contract is a MEC, all cash value transactions are subject to taxation and penalty. - Funds are subject to a 10% penalty on gains withdrawn prior to age 59 ½. - This is considered a premature distribution. - Distributions made on or after 59 ½ and distributions paid out due to death or disability are not subject to the penalty.

Simplified Employee Pensions (SEPs)

- Simplified Employee Pensions (SEPs) are set up by any private sector company that does not offer another type of qualified plan. - This plan is very popular with self-employed individuals. - The SEP plan uses employer funded IRAs. The employer makes contributions that are tax deductible. - Annual contributions are limited to maximums set by the IRS. - All distributions to employees are taxable at the time of withdrawal and subject to a penalty if prior to age 59 1/2.

Tax-Sheltered Annuities

- Tax-Sheltered Annuities (TSA) are qualified annuity plans benefiting employees of public schools under the Internal Revenue Code (IRC) Section 403(b), as well as other nonprofit organizations qualified under Section 501(c)(3). - Employees of nonprofit organizations may have an arrangement with the employer whereby the employer agrees with each participating employee to reduce the employee's pay by a specified amount and invest it in a retirement fund or contract for the employee. - Employees do not make direct payments to the retirement fund. - These accounts are owned by the employee and are nonforfeitable and will be paid upon death, retirement, or termination of the employee. - Contributions are pretax and interest earned grows tax deferred.

Profit-Sharing and 401(k) Plans

- A 401(k) Plan is a defined contribution plan for employees of for-profit companies. It is an elective deferral plan or salary reduction. - 401(k) Plans also can be profit-sharing plans allowing an employee a choice between taking income in cash or putting the income into a qualified plan and deferring that portion of income. - If employees elect a defined contribution plan: Employees define their contribution amount as a percentage of income or a fixed dollar amount per payroll period. -> The employer must deduct that amount from pay and forward to the plan custodian on a timely basis. Participants typically invest in a portfolio of mutual funds. Employers may contribute and match funds to participant accounts as long as the contribution formula is not discriminatory. - If the plan is incorporated as a profit-sharing plan: -> The employer defines the circumstances under which profit-based contributions will be made, and contributions must generally be made in at least 3 out of 5 consecutive years.

Roth IRA

- A Roth IRA is a nondeductible tax-free retirement plan for anyone with earned income. - The IRS sets maximum annual contribution limits, plus a catch-up contribution for persons aged 50 or older. - Unlike a traditional IRA, contributions are not tax deductible. - If the account has been open for at least 5 years and the owner is at least 59½, qualified distributions are tax-free. - The owner may take a tax-free, penalty-free distribution in case of death, disability or qualified first-time home purchase. - A nonqualified distribution is subject to taxation of earnings and a 10% additional tax unless an exception applies. - If a person owns a traditional IRA and a Roth IRA, the combined contributions to both cannot exceed the annual maximum IRA contribution for one IRA.

Savings Incentive Match Plan for Employes (SIMPLE)

- A SIMPLE plan may be established either as an IRA or a 401(k) plan. - The employer's contribution must be immediately vested at 100%. - This means that the employee is entitled to all the employers' contributions immediately. - SIMPLE plans are only available to companies that have fewer than 100 employees and must be the only type of plan the company has available for the employees. - An advantage of a SIMPLE plan is the elimination of high administrative costs.

Cash Values

- A cash value policy will experience increases in the cash value annually. - Part is from the premium and part is from any interest or gains. - The interest or gains are not taxable at the time they are credited to the policy. - Any earnings in the cash value are allowed to grow on a tax-deferred basis until one of the following events occurs: -> The policy is surrendered. -> The policy is transferred for value (such as being sold or assigned) -> The policy ceases to meet the IRS definition of a life insurance contract.

Defined Benefit Plan

- A defined benefit plan provides employees with a fixed and known benefit at retirement, the amount of which depends upon length of service and highest attained salary. - The company assumes the responsibility for making sure money will be available to fund a pension for retiring workers. - Commonly known as pension.

Defined Contribution Plan

- A defined contribution plan provides employees with a retirement benefit based on the value of the employee's account at retirement. - The employee chooses how much of their pay to contribute to the plan each payroll period. The employer deducts that amount from the employee's pay before income tax is calculated and remits that amount to the plan's custodian for the benefit of the employee. - The employer and employee or both can make contributions. - This is a type of retirement plan in which a certain amount or percentage of money is set aside each year by a company for the benefit of the employee.

Dividends

- A participating insurance company's dividend consists of the amount of premium that is returned to the policyowner if the insurance company achieves lower mortality and expense costs than expected. - Dividends are paid out of the insurer's surplus earnings for that year. - The dividends themselves are not taxable since dividends are considered a return of unearned premium. - When dividends: -> Are left on deposit with the insurance company, interest earned on dividends is taxable as ordinary income in the year earned. -> Received exceed the total premium paid for the life insurance policy, the excess dividends are then considered taxable income.

Corporate-Owned Annuities

- An annuity contract owned by a non-natural person is not treated as an annuity for federal income tax purposes, so the contract's gains are currently taxed as opposed to being tax deferred. - In short, there are no tax benefits when an annuity is owned by a corporation.

Traditional IRAs

- Anyone with earned income may open a traditional IRA. - Contributions may be tax deductible in whole or part (or nondeductible if the owner is a participant in an employer-sponsored retirement plan and gross income exceeds certain thresholds). - A nonworking spouse can also set up a Spousal IRA based on the working spouse's income. - Contributions grow tax-deferred until they are withdrawn. - There is a maximum annual contribution allowed by the IRS, as well as a "catch-up" contribution for persons age 50 and older. - All amounts contributed pretax plus gains withdrawn from an IRA are fully taxable as ordinary income.

Executive Bonus Plans

- Are considered to be nonqualified plans. - An executive bonus plan is one in which an employer pays the premiums on a permanent life insurance policy owned by an employee. - The employer may be able to deduct salary and compensation under Section 162 of the Internal Revenue Code (IRC). - Since this plan is designed to provide a salary to the employee upon retirement, the premiums within limits are tax deductible to the employer and the income is taxable to the employee when paid out. - These plans are nonqualified because they are designed to discriminate in favor of highly compensated key employees. - While the employer pays the initial premiums, additional funds can be deposited by the employee.

Individual Retirement Accounts

- Because IRAs are established by individuals, they are not considered qualified plans and have their own set of rules. - This means an individual can set up a traditional or Roth IRA, whether or not the employer has established a qualified plan at work.

Exclusion Ratio

- In general, the way in which taxation of annuities is computed is referred to as the exclusion ratio. - The IRS has tables and formulas to determine which part of the income benefit payment is tax-free return of premium and which part is taxable. - After the entire cost basis is recovered then any future income benefit payments received are fully taxable. - A withdrawal is any amount distributed from the annuity that is not part of the annuitization process. - Investments are taxed on a LIFO basis. - That means for income tax purposes the first money out of the annuity will be considered as earnings, not principal, and will be taxed as ordinary income when withdrawn from the contract. - Additionally, withdrawals made prior to the annuitant's age 59½ are generally subject to a 10% early withdrawal penalty. - To determine which part of each payment is taxable and which is not, the IRS allows the annuitant to use an exclusion ratio. - According to the IRS, the part of each annuity payment that represents the cost basis is in the same proportion that the investment in the contract is to the expected return. - The expected return is affected by the settlement option chosen and is based on the total amount the annuitant can expect to receive under the contract. - For variable annuity income payments, determining the amount of each payment that is tax-free is by dividing the investment in the contract by the total number of periodic payments expected to be received, based on the settlement option selected under the contract. - The income tax due is based on the annuitant's ordinary income tax rates.

IRA Transfer

- In many cases, IRA assets can be transferred directly into a new account. - An IRA transfer is the movement of funds between the same type of plan, such as two IRA accounts. - The money is transferred directly from one financial institution to another. - Transfers are not taxable and can take place as often as desired.

Taxable

- Interest received from a life insurance death benefit settlement option. - Withdrawals, cash surrenders, and policy loans distributed from a MEC up to an amount equal to the earnings. - Interest earned on policy dividends. - Death benefits included in an insured's estate. - Life insurance cash withdrawals or surrenders that exceed the cost basis.

Section 1035 Exchanges

- Internal Revenue Code Section 1035 allows for the exchange of an existing insurance policy or contract for another without incurring any tax liability on the interest and/or investment gains in the current contract. - These tax-free exchanges, known as 1035 exchanges, can be useful if another insurance policy has features and benefits that are preferred or are superior to those found in an existing contract. - Policyowners must be aware that surrender charges might still apply on the existing contract, and a new surrender charge period may start after the exchange on the newly acquired policy. - Further, the new insurance contract may have higher fees and charges than the old one which will reduce the returns or increase costs for such things as policy loans. - Types of exchanges the IRS will allow on a tax-free basis are from: -> Life insurance to life insurance -> Life insurance to an annuity -> Annuity to an annuity -> Life insurance or annuity to long-term care -> However, the IRS will never allow an annuity to life insurance exchange on a tax-free basis. - When moving from an existing life insurance policy to a new life insurance policy as part of a 1035 exchange, the new life insurance policy will be issued only after a new application for coverage is received, and the policy is issued and accepted.

Self Employed Plans (HR-10 or KEOGH Plans)

- KEOGH Plans, or HR-10 Plans, are available to unincorporated sole proprietors and their eligible employees. - Silent partners are not eligible. - Contributions for eligible employees are mandatory and based on the percentage of contribution made by the employer for their own account. - These contributions are deductible. - Before a tax law change in 2001, Keogh Plans were a popular choice for high-income self-employed people. - Today, they have been largely replaced by SEP IRAs, which have the same contribution limits but much less paperwork.

Qualified Plans

- Must meet the requirements of ERISA (Employee Retirement Income Security Act), which is a federal law that sets minimum standards for pension plans in private industry. - ERISA does not require any employer to establish a pension plan. - It only requires that those who establish plans must meet certain minimum standards. - ERISA qualified plans: -> Must benefit employees and beneficiaries. -> May not discriminate in favor of highly compensated employees. -> Must be approved by the IRS. -> Have a vesting requirement. - Qualified plans receive favorable tax treatment. - Employer contributions are tax-deductible to the employer immediately and are not taxable to the employee until withdrawn. - Employee contributions are either pretax or tax deductible. - Distributions taken prior to age 59 ½ are subject to taxation and a 10% penalty. - The penalty may be waived for death, disability, qualified education costs, medical expenses, first-time home buyers and substantial equal payments over life expectancy.

Life Insurance is NOT a __________ ____________ in an IRA?

- Permissible Investment

Income-Tax Free

- Policy loan from an in-force policy. - Lump sum death benefit paid to a beneficiary. - Qualified accelerated death benefit. - Policy dividend that is less than the premium paid. - Group life insurance death benefit proceeds (lump sum).

Modified Endowment Contacts (MECs)

- Prior to 1988, individuals could place large sums of money into a cash value policy (typically in a lump sum), and the cash would grow tax deferred until the insured died, at which point a death benefit was paid income tax-free. - Alternatively, if they needed cash, they could take a tax-free lifetime loan or withdrawal. - These policies were used in place of investment vehicles to avoid paying taxes. - Under current law, if a policy is funded too quickly it will be classified as a Modified Endowment Contract (MEC). - MEC rules impose stiff penalties to eliminate the use of life insurance as a short-term savings vehicle.

Individual Annuities

- Tax-qualified annuities are generally funded with pretax dollars. - They are also fully taxable at ordinary income rates when money is withdrawn because the premiums paid and subsequent premiums do not establish a cost basis. - Nonqualified annuities are generally funded with after-tax dollars. - The premium paid for the nonqualified annuity, along with any subsequent premiums, establishes the cost basis for the nonqualified annuity. - In simple terms, the cost basis equals the total amount paid for a deferred annuity. - The basis is the starting point for establishing gain or loss. - Any interest or other gains during the accumulation phase of the annuity are tax deferred. - If the policy is cashed out for a lump sum, then any amount received in excess of the cost basis is taxable as ordinary income. - If the policy is annuitized then the original investment is returned in equal tax-free installments over the payment period. - These payments are not taxed since they are simply a return of principal while the balance of monies received in annuity payments is the taxable gain or earnings. - This is taxed at ordinary income tax rates even if the gains come from the investment separate accounts found within a variable annuity.

Required Minimum Distributions (RMDs)

- Taxable distributions must begin by April 1 after the year the account owner reaches age 73. - Failure to take all or part of an annual RMD will result in a 50% penalty tax on the amount not distributed.

Rollovers and Transfers of IRAs

- The IRS permits an IRA rollover from one account to another or a transfer. - This may avoid taxation as an early withdrawal.

Death Benefit Proceeds (Claim)

- The death benefit, or face amount, of the policy is generally not considered taxable income when paid as a lump sum death benefit to a named beneficiary. - If a settlement option is used instead of a lump sum payment, any interest or earnings component of each payment would be considered taxable as ordinary income.

Accelerated Death Benefits

- The payment of an accelerated death benefit is tax-free to a recipient if the benefit payment is qualified. - To be a qualified benefit, it must meet the following conditions: -> A physician must give a prognosis of 24 months or less life expectancy for the named insured. -> The amount of the benefit must at least be equal to the present value of the reduced death benefit remaining after payment of the accelerated benefit. -> The insurer provides a monthly report for the insured showing the amount paid and the amount of benefit remaining in the life insurance policy.

Life Insurance Transfer for Value Rule

- The transfer-for-value rule was passed by Congress to discourage business transfers of ownership between parties looking to take advantage of the tax-free status of life insurance death benefits. - If a life insurance policy is transferred to a new owner in return for any kind of material consideration, the transfer-for-value rule partially removes the tax-exempt status of a life insurance policy. - The rule states that the amount of the death benefit that exceeds the value of consideration and any additional premium paid will be taxed as ordinary income. - If the transfer qualifies as an allowable exception to the rule, the death benefit will be paid tax-free.

Qualified Retirement Plan Types, Characteristics and Purchasers:

- There are two broad categories of qualified retirement plans: -> Defined Benefit Plan -> Defined Contribution Plan

7-Pay Test

- When a contract does not pass the 7-pay test, it will be deemed a MEC. - The 7-pay test is a limitation on the total amount that can be paid into a policy in the first 7 years. - It compares premiums paid for the policy during the first 7 years with the net level premiums that would have been paid on a 7-year Pay Whole Life policy providing the same death benefit. - As long as the policy premium guidelines are met, the policy will avoid being deemed a Modified Endowment Contract. - If a policyowner pays premiums in excess of the guidelines, the excess premium can be refunded by the insurer within 60 days after the end of the contract year. - Since a single premium life insurance policy clearly does not pass the 7-pay test, it will automatically be deemed a MEC.

Distributions at Death

- When the annuitant dies during the accumulation phase of the annuity, the beneficiary receiving the death benefit must pay income tax on any gain embedded in the policy, at ordinary income tax rates.

Premature Distributions

- Withdrawals before age 59½ are generally subject to a 10% penalty tax.