ND Life - Federal Tax Considerations for Life Insurance

In settlement options, the _________ is tax free, but the ________ is taxable.

In settlement options, the PRINCIPAL is tax free, but the INTEREST is taxable

Are premiums tax deductible in life insurance policies?

NO

Is the death benefit of a life insurance policy taxed to the beneficiary if it's received as a lump sum?

No, lump-sum benefits are received tax free

What is the name for an overfunded life insurance policy?

a Modified Endowment Contract (MEC)

Modified Endowment Contract (MEC)

an overfunded life insurance policy. Fails the 7-pay test. Once a MEC, ALWAYS a MEC!

What is the main purpose of the 7-pay Test?

to determine if a life insurance policy is a Modified Endowment Contract

When would life insurance policy proceeds be included in the insured's taxable estate?

when there is an incident of ownership at the time of death

Tax Considerations for Life Insurance and Annuities: Partial Surrenders

First In, First Out (FIFO)

Tax Considerations for Life Insurance and Annuities: Cash Value Gains

Taxed at surrender

Exclusion ratio

calculation method used to determine the annuity amounts to be excluded from taxes

According to the taxation rules of life insurance policies, how are cash value increases taxed?

cash value growth is tax deferred

Vesting

the right of a participant in a retirement plan to retain part or all of the benefits

Tax Considerations for Life Insurance and Annuities: Policy Loans

Not income taxable

Tax Considerations for Life Insurance and Annuities: Death Benefit

Not income taxable (except for interest)

Which of the following statements is TRUE concerning whole life insurance? a. Policy loans are tax deductible b. Lump-sum death benefits are not taxable c. Dividend interest is not taxable d. Premiums are tax deductible

b. Lump-sum death benefits are not taxable dividend interest is taxable; policy loans are not tax deductible, and premiums are not tax deductible.

FIFO (First In, First Out)

principle under which it is assumed that the funds paid into the policy first will be paid out first

Tax Considerations for Life Insurance and Annuities: Dividends

Not taxable (return of unused premium; however, interest is taxable)

When a beneficiary receives payments consisting of both principal and interest portions, what parts are taxable as income? a. Neither principal nor interest b. Principal only c. Interest only d. Both principal and interest

c. Interest only If a beneficiary receives payments that contain both principal and interest portions, only the interest is taxable as income

Policy proceeds

in life insurance, the death benefit

Policy endowment

maturity date

Would a lump-sum cash payment of life policy proceeds be tax free for the beneficiary?

YES

In life insurance policies, cash value increases a. Are income taxable immediately b. Are taxed annually c. Are only taxed when the owner reaches age 65 d. Grow tax deferred

d. Grow tax deferred Generally life insurance cash values are only income taxed if the policy is surrendered (totally or partially) and the cash value exceeds the premiums paid

Tax Considerations for Life Insurance and Annuities: Premiums

Not deductible (personal expense)

Policy loans from the cash value are _______ income taxable

Policy loans from the cash value are NOT income taxable

If the beneficiary of a life insurance policy receives death benefit payments that consist of principal and interest, which portion, if any, will be taxed?

interest only

Upon surrender of a life insurance policy, what portion of the cash value will be taxed?

only the portion in excess of the premium paid

Tax Considerations for Life Insurance and Annuities: Estate Tax

If the insured owns the policy, it will be included for estate tax purposes. If the policy is given away (possibly to a trust) and the insured dies within 3 years of the gift, the death benefit will be included in the estate.

Tax Considerations for Life Insurance and Annuities: Cash Value Increases

Not taxable (as long as policy in force)

Tax Considerations for Life Insurance and Annuities: Surrenders

Surrender value - past premium = amount taxable

True of False? Taxes must be paid either upon contribution or upon distribution, NOT both (if taxed on one end, will not be taxed on the other)

TRUE

What portion of a nonqualified annuity payment would be taxed?

interest earned on principal

Which of the following describes the taxation of an annuity when money is withdrawn during the accumulation phase? a. Withdrawn amounts are taxed on a last in, first out basis b. Withdrawn amounts are taxed on a first in, last out basis c. Taxes are deferred on withdrawn amounts, but a flat penalty is charged d. Taxes are deferred on withdrawn amounts

a. Withdrawn amounts are taxed on a last in, first out basis

Death benefits payable to a beneficiary under a life insurance policy are generally a. Exempt from income taxation if over $10,000 b. Not subject to income taxation by the Federal Government c. Subject to income taxation by the Federal Government d. Exempt from income taxation if under $10,000

b. Not subject to income taxation by the Federal Government When premiums are paid with after tax dollars, the death benefit is generally not subject to federal income taxation

An insured decides to surrender his $100,000 Whole Life policy. The premiums paid into the policy added up to $15,000. At policy surrender, the cash surrender value was $18,000. What part of the surrender value would be income taxable? a. $50,000 b. $18,000 c. $15,000 d. $3,000

d. $3,000 The difference between the premiums paid and the cash value would be taxable. In this example, the difference between the premiums paid ($15,000) and the cash value ($18,000) is $3,000.

Which of the following is used to determine the annuity amounts that are not taxable? a. Pro rata ratio b. Exclusion index c. Market-adjusted annuities index d. Exclusion ratio

d. Exclusion ratio The "exclusion ratio" is used to determine the annuity amounts that should be excluded from taxes. During the accumulation phase, the contributions to the annuity have already been taxed. Therefore, the contributions are not taxed during the income period.

Which of the following statements is TRUE concerning whole life insurance? a. Dividend interest is not taxable b. Premiums are tax deductible c. Policy loans are tax deductible d. Lump-sum death benefits are not taxable

d. Lump-sum death benefits are not taxable

If a life insurance policy develops cash value faster than a seven-pay whole life contract, it becomes a/an a. Modified endowment contract b. Accelerated benefit policy c. Endowment d. Nonqualified annuity

a. Modified endowment contract Any cash value life insurance policy that develops cash value faster than a seven-pay whole life contract is called a Modified Endowment Contract (MEC). It loses the benefits of a standard life contract.

What type of annuity activity will cause immediate taxation of the interest earned? a. Surrendering the annuity for cash b. Using the contract as collateral for a loan c. Changing a settlement option d. Failing to make a planned contribution

a. Surrendering the annuity for cash One-sum cash surrenders give rise to immediate taxation of the interest earned

Which of the following is NOT true regarding policy loans? a. A policy loan may be repaid after the policy is surrendered b. Money borrowed from the cash value is taxable c. Policy loans can be repaid at death d. An insurer can charge interest on outstanding policy loans

b. Money borrowed from the cash value is taxable Money borrowed from the cash value is NOT taxable. Policy loans can be repaid at any time, including surrender and death. An insurer can charge interest on outstanding policy loans

Which of the following is NOT true regarding policy loans? a. A policy loan may be repaid after the policy is surrendered b. Money borrowed from the cash value is taxable c. Policy loans can be repaid at death d. An insurer can change interest on outstanding policy loans

b. Money borrowed from the cash value is taxable NOT TRUE. Money borrowed from the cash value IS TAXABLE.

An insured has a Modified Endowment Contract. He wants to withdraw some money in order to pay medical bills. Which of the following is true? a. He will have to pay a penalty regardless of his age b. He will not have to pay a penalty, regardless of his age c. He cannot withdraw money from his MEC before age 59 1/2 yrs old d. He will have to pay a penalty if he is younger than 59 1/2 yrs old

d. He will have to pay a penalty is he is younger than 59 1/2 Any cash value life insurance policy that develops cash value faster than a seven-pay whole life contract is called a Modified Endowment Contract (MEC). It loses the benefits of a standard life contract. All withdrawals are subject to taxation on a LIFO (Last In, First Out) basis, and if withdrawals are made earlier than the age of 59 1/2, a 10% penalty is imposed.

An annuitant dies before the effective date of a purchased annuity. Assuming that the annuitant's wife is the beneficiary, what will occur? a. The interest will continue to accumulate tax deferred b. The interest will become immediately taxable c. The premiums will increase d. The premiums will decrease

a. The interest will continue to accumulate tax deferred If the contract holder dies before the annuity starting date, the contract's interest becomes taxable. If the beneficiary of the annuity is a spouse, the tax can continue to be deferred.

If $100,000 of life insurance proceeds were used in a settlement option, which paid $13,000 per year for ten years, which of the following would be taxable annually? a. $7,000 b. $3,000 c. $13,000 d. $10,000

b. $3,000 If $100,000 of life insurance proceeds were used in a settlement option paying $13,000 per year for 10 years, $10,000 per year would be income tax free (as principal) and $3,000 per year would be income taxable (as interest).

Which of the following statements regarding the taxation of Modified Endowment Contracts is FALSE? a. Policy loans are taxable distributions b. Accumulations are tax deferred c. Withdrawals are not taxable d. Distributions before age 59 1/2 incur a 10% penalty on policy gains

c. Withdrawals are not taxable

FIFO Method applies to _____ insurance ONLY.

FIFO method applies to LIFE insurance ONLY. The policyowner will receive their investment in the contract first before receiving any gains in the policy (or being taxed on those gains). Annuities follow a LIFO (Last In, First Out) format.

Tax Considerations for Life Insurance and Annuities: Accumulations

Interest taxable

Which of the following statements is TRUE concerning whole life insurance? a. Lump-sum death benefits are not taxable b. Dividend interest is not taxable c. Premiums are tax deductible d. Policy loans are tax deductible

a. Lump-sum death benefits are NOT taxable

If an immediate annuity is purchased with the face amount at death or with the cash value at surrender, this would be considered a a. Settlement option b. Nontaxable exchange c. Nonforfeiture option d. Rollover

a. Settlement option A settlement option is exercised when an immediate annuity is purchased with the face amount at death or with the cash value at surrender

Which of the following terms is used to name the nontaxed return of unused premiums? a. Surrender b. Dividend c. Premium return d. Interest

b. Dividend The return of unused premiums is called a dividend. Dividends are not considered to be income for tax purposes, since they are the return of unused premiums

If taken as a lump sum, life insurance proceeds to beneficiaries are passed a. Without interest b. Free of federal income taxation c. Tax-deductible d. Part tax-free and part taxable

b. Free of federal income taxation Life insurance proceeds to beneficiaries are passed free of federal income taxation if taken as a lump sum distribution. If the proceeds are taken as other than lump sum, part of the proceeds will be tax-free and part will be taxable. When paid in installments, part of the proceeds contains principal and some interest, so the interest portion is subject to federal income taxation.

What is the main purpose of the Seven-pay Test? a. It guarantees the minimum interest b. It determines if the insurance policy is a MEC c. It requires level premium payments for 7 years d. It ensures that the policy benefits are paid out in 7 years

b. It determines if the insurance policy is a MEC The Seven-pay Test determines whether an insurance policy is "over-funded" or if it's a Modified Endowment Contract. In other words, the cumulative premiums paid during the first seven years of must not exceed the total amount of net level premiums that would be required to pay the policy up using guaranteed mortality costs and interest.

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? a. Annuitant b. Spouse c. Charitable organization d. Dependents

b. Spouse If an annuities contract holder dies before the effective starting date, the contract's interest continues to be taxable, unless the beneficiary is a spouse. In that case, this tax can be deferred.

Which of the following best describes taxation during the accumulation period of an annuity? a. The growth is subject to immediate taxation b. Taxes are deferred c. The annuity is subject to state taxes only d. The annuity is subject to both state and federal taxation

b. Taxes are deferred The interest accumulated in an annuity is the tax base, but the taxes are deferred during the accumulation period. The cost base is the premium dollars that have already been taxed and will not be taxed again when withdrawn from the contract

Which concept is associated with "exclusion ratio"? a. How exclusion riders affect an insurance premium b. Policy provisions c. Annuity payments d. Dividend distribution

c. Annuity payments A portion of an annuity payment is taxable, while another portion is not. The return of the principal paid in is nontaxable. The portion that is taxable is the actual amount of payment, less the expected return of the principal paid in. This relationship is called the "exclusion ratio"

Which of the following is true regarding taxation of dividends in participating policies? a. Dividends are taxable in some life insurance policies and nontaxable in others b. Dividends are considered income for tax purposes c. Dividends are not taxable d. Dividends are taxable only after a certain amount is accumulated annually

c. Dividends are NOT taxable Dividends are not considered to be income for tax purposes, since they are the return of unused premiums. The interest earned on the dividends, however, is subject to taxation as ordinary income.

If an insured surrenders his life insurance policy, which statement is true regarding the cash value of the policy? a. It is taxable only if it exceeds the amounts paid for premiums by 50% b. It is automatically taxable c. It is only taxable if the cash value exceeds the amount paid for premiums d. It is not considered to be taxable

c. It is only taxable if the cash value exceeds the amount paid for premiums The cash value of a surrendered policy is only considered to be taxable as income if the cash value exceeds the amount of premiums paid for the policy.

During the accumulation period in a nonqualified annuity, what are the tax consequences of a withdrawal? a. Both interest and principal are taxed; no other penalties are imposed b. Neither interest nor principal is taxed, but penalties may be imposed c. Taxable interest will be withdrawn first and the 10% penalty will be imposed if under age 59 1/2 years d. Nontaxable principal may be withdrawn first, but the 10% penalty will be imposed if under age 59 1/2 years

c. Taxable interest will be withdrawn first and the 10% penalty will be imposed if under age 59 1/2 years. When money is withdrawn from the annuity during the accumulation phase, the amounts are taxed on a last in first out basis (LIFO). Therefore, all withdrawals will be taxable until the owner's cost basis is reached.

Which of the following statements regarding the taxation of Modified Endowment Contracts is FALSE? a. Policy loans are taxable distributions b. Accumulations are tax deferred c. Withdrawals are not taxable d. Distributions before age 59 1/2 incur a 10% penalty on policy gains

c. Withdrawals are not taxable Any distributions from MECs are taxable, including withdrawals and policy loans. All of the other statements are true

Which of the following describes the taxation of an annuity when money is withdrawn during the accumulation phase? a. Taxes are deferred on withdrawn amounts, but a flat penalty is charged b. Taxes are deferred on withdrawn amounts c. Withdrawn amounts are taxed on a last in, first out basis d. Withdrawn amounts are taxed on a first in, last out basis

c. Withdrawn amounts are taxed on a last in, first out basis When money is withdrawn from the annuity during the accumulation phase the amounts are taxed on a last in, first out basis (LIFO). Therefore, all withdrawals will be taxable until the owner's cost basis is reached. After all of the interest is received and taxed the principal will be received with no additional tax consequences.

When the owner of a $250,000 life insurance policy died, the beneficiary decided to leave the proceeds of the policy with the insurance company and selected the Interest Settlement Option. If at the time of withdrawal the interest paid was $11,000, the beneficiary would be required to pay income tax on a. None, because the beneficiary has not received the death benefit b. $261,000 c. $239,000 d. $11,000

d. $11,000 The death benefit is not income taxable; any interest earned is income taxable

Life insurance death proceeds are a. Taxable to the extent that they exceed 7.5% of the beneficiary's adjusted gross income b. Taxed as a capital gain c. Taxed as ordinary income d. Generally not taxed as income

d. Generally not taxed as income Life insurance death benefits are generally not taxed as income

What method is used to determine the taxable portion of each annuity payment? a. The excise ratio b. The annuity to age ratio c. The marginal tax formula d. The exclusion ratio

d. The exclusion ratio The ratio of the total investment in that contract to the expected return is developed to determine the portion of the annuity payment that will be taxable and nontaxable.

Which of the following statements regarding the taxation of Modified Endowment Contracts is FALSE? a. Distributions before age 59 1/2 years incur a 10% penalty on policy gains b. Policy loans are taxable distributions c. Accumulations are tax deferred d. Withdrawals are not taxable

d. Withdrawals are not taxable Any distributions from MECs are taxable, including withdrawals and policy loans. All of the other statements are true.

Tax Considerations for Life Insurance and Annuities: Settlement Options

death benefit spread evenly over income period (averaged). Interest payments in excess of death benefit portion are taxable.

What is the general taxation rule for death benefits payable to the beneficiary of a life insurance policy?

death benefits are generally not subject to income taxes

Why are dividends in life insurance policies not taxable?

dividends are not considered income for tax purposes; they are a return of unused premium

In a direct rollover, how is the money transferred from one retirement plan to a new one?

from trustee to trustee

LIFO (Last In, First Out)

principle applied to asset management in life insurance products, under which it is assumed that the funds paid into the policy last will be paid out first

Tax deferred

taxes on investments or gains (such as interest or dividends) are paid at a future date instead of in the period in which they are incurred tax