AD Banker CH 7

Modified endowment Contract (MEC's)

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 deffered until the insured died at which point a death benefit paidd income tax free. or of they needed cash, they could take a tax free lifetime loan. These policies were used 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 a stiff penalties to eliminate the used if life insurance as short term savings vechicle

Taxation

if a contract is deemed to be MEC then any fund that are distributed are subject tot a 'Last-in First-Out" (LIFO) tax treatment, rather than the normal "first in first out" tax treatment. Taxable distributors incldiue a partial withdrawals, cash value surrenders and policy loans (including automatic premium loans)

Estate Taxes and Considerations

when an individual life insurance policy Is owner by the insured, the vlaueof the death benefit may be included in the insured estate, wither intentionally or be default. The policyownre may name the estate as a beneficiary. These values will be added to the amount in the estate and potentially be subject to federal estate taxes

Distributions at Death

when the annuitant dies during the accumulation phase o the annuity the beneficiary receiving the death benefits must pay income tax on any given embedded un the police at the ordinary income tax rates .

Cashed Out for Lump Sum

then any amount received in excess of the cost basis is taxable as ordinary income

Cash Value Formula

(cash value) - (sum of premiums) = equity

Taxation of Non-qualified Annuities

-Accumulaiton Phase : upon contact surrender or partial withdrawal -taxed on earned interest -penalty may apply Distribution at Death -Beneficary is subject to taxation of earning if worn dies during accumulation phase Annuity Phase -Percentage of prinvcipal to interest determines the exclusion ratio Estate Taxations -during the accumulation phase if the contract owner dies the value of the annuity is included in the owners estate for valuation -during the annuity phase the total remains in an account is included in the deuces annuitants. estate -this applies for settlement options except for the pure life income options, since the company keeps any unpaid proceeds

When dividends

-Are left on deposit with the insurance company, interest waned on divides is taxable as ordinary income in the year earned -Receieved exceed the total premium paid for the life insurance policy, the excess dividends are then considered taxable income

Death Benefits Proceeds

-Face amount (principal) -Not taxable -Interest -taxable when received in a installations as part of a settlement options

Premiums

Individuals :Premijms not deductible Employer: Premiums tax deductible as business expense , as long as the business does not derive a direct benefits from the policy Group : employer paid premiums are not taxable to employee unless benefit exceeds $50,000

Types of Exchanges the IRS will allows on a tax-free basis are from:

-Life insurance to Life insurance -Life insruacn to an annuity -Annuity to an annuity -Life insurance or annuity to long term care -But never an annuity to life insurance A 1035 exchange will only take place after the newly applied for the policy has been insured and accepted. Once the free look period has elapsed, the new insurer will request cancellation of the old policy and transfer of the cash value .

1035 Tax Free Exchange

-internal revenue cose 1035 provides that no gains or loss is recognized on certain exchanges between contract -Life policy to Life policy -Life policy to annuity -annuity to annuity Never annuity to life policy

Dividends

Consist of the amount of premiums that is returned to the pokciyowner if the insurance company achieves lower mortally and expenses costs than expected. Dividends are paid out of the insurers surplus for that year. The dividends are not taxable since the dividends are considered a return of unearned premium.

Exclusion Ratio Formula

Cost Basis / Expected Return = % of each payment that will be excluded from taxation s

Death Benefit Proceeds

Death benefits proceeds from a group life insurance plan to an employee named beneficiary are received income tax fee.

Estate Taxations

During the accumulation pasha, if the contract owner dies, the value of the annuity is included in the owners estate for valuation. If the annuitant dies during the annuity or payout phase the remianif value in the account will be added to the deceased annuitant estate for valuation. However if the annuitant was receiving income from a pure life or straight life annuity the company keeps the balance and nothing is included in the annuitant estate for valuations

Premium Paid by the employer and the Employee

Groups term life premiums paid by an employer are tax deductible to the business as a ordinary and nessesaryt business expense. Any employee paid premiums are not eligible for the tax deductions. Employer paid premiums in connection with group life insurance do not consittute taxable income to the employee unless the death benefit paid for by the employer exceeds $50,000. All employers paid premiums for amount above $50,000 are reported as taxable income to the employee.

Accelterated Death Benefits Proceeds

If an insured qualifies (terminally ill) benefits are not taxable -Considered an advance of death benefits while the insured is still living

Quilfied Retirement Plans

Qualified pension and profit sharing plans were created by Congree to help employees accumulate assets for retirement and provide tax advantages for contributions made by employers, While there are genera lay no specific limitations on the typed assets that may be purchased to fund these pans, there limitations on th types of benefits which may be included in the qualified plan. Speacifuallly there is restrictions on the aojhnt of life insurance that can be held in a qualified plan. The restrictions is referred to as the incidental benefits limitation and the IRS developer standard or rules to determine the allowed able limits. Generally life insurance will be considered 'incidental to qualified plan if no more than 50% of the contributors are sued to pay induce premiums, and the insurer amount is not ore that 100 times the expected monthly benefit amount.

Accelerated Death Benefits

The payment of an accelerated death benefits is tax free to a recipient if the benefits payment os a qualified. To be a qualified benefits, the benefits must meet the following conidionts -A physical must give a prognosis of 24 months or less life expectancy for he named insured -The amount of the benerofts must at least be equal to the balance of a the face amount remains after payment of the accelerated benefits. The total major of the payout cannot be less that 100% of the original face amount. -The insured provides a monthly report for the insured showing the amount paid and the naojtn of benefits remaining ins the life insurance policy

7-Pay Test

When a contract does not pass the 7-Pay Tess, it will be deemed a MEC> The 7-Pay test is a limitation on the Toal amount that can be paid into a policy in the first 7 years. It comprises premiums paid for the policy during the first 7 years with he bet level premiums that have been paid on 7-Pay whole life policy providing the same death benefits. As long as the policy premium guidelines are met, the policy will avoid being deemed a modified endowmwner contract. If the policowner pays premiums in excess of the guidelinesm the excess premiums can be refunded by the insure within 60 days after the end of the contract year. Since a singles premium life insurance policy clearly does not pass the 7-pay test it will automatically be deemed a MEC The other types of policies that could be classified a MEC's are flexible premium policies such as Universal and Variable universals life. The flexible premiums features allows the owner to pay premiums on their own schedule. Once a policy is classified as a MEC, it will maintain that classification for the life of the policy. The overfunding cannot be undone in the future years

Life Insurance Transfer for Value Rule Example

a $500,000 policy is transferred to a new owner and sold for $50,000. after the sale the new owner pays $10,000 in life insuradne premiums while the insured is alive. Upon death of the insured $60,000($50,000 + $10,000) of the death benefits is received income tax free too the benefitacry while $440,000 is taxable ($500,000-$60,000)

Cash Values

a cash value policy may experience increases in th 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 -Policy is surrended -Policy is transferred for value (sold or assigned -Policy ceases to meet the IRS definitions of a life insurance contract

Corporate Owned Annuities

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

Withdrawal or Partial Surrender

any amount distributed from the annuity that is not part of the annuititzation process. Distribution are taxed on a last in, first out basis (LIFO). That means for income tax purposed the first money out of the annuity will be gains, not principal and will be taxed as ordinary income when the withdrawn from the contract. Additionally withdrawals made a prior to the annuitant age 59 1/2 are generally subject to a 10% early withdrawl penalty

Surrendering Cash Value Life Insurance Policy

any gains will be subject to federal, and possibly state income tax. The gain on the surrender of a cash value policy is the difference between the gross cash value paid out, plus any loans will be paid as a lump sun. As with other distributions made while he insured is alive, the sum is excess of the cost basis is taxable as ordinary income

Premiums

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

Tax-qualified annuities

are funded with pre tax dullard. Their also full taxable at ordinary income rates when money is withdrawn becasue the premiums paid and subsequent premiums do not establish a cost basis

Annuity Distribution from a variable annuity

are treated in slightly different manner. Because the monthly payment can go up and down depending on a separate account pefroamcne the ament of future annuity payments can also go up or down. The IRS Rules assume that there will be nor change in payments over the life time of th enanuittant, Once the exclusion amount is determined it does not change, if acuamtyl monthly payetna go down the taxable portions will be lower, and if payments go up the taxable portion will be higher

Non-Qualified Annuities

arr funded with after-tax dollars. The premium paid for the nonqualified annuity along with any subsequent poreiums, established;ish the cost basis for the non qualified annuity. In simple term th escort basis equals the total amount paid for the annuity. The basis is the starting point for establishing gains in the contract at the time of distribution or surrender. any interest or other gains during the accumulation phase of the annuity are tax deferred

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 1/2. This is considered a premature distributions. Distrubtions made on or after 59 1/2 and distributions paid out due to death or disability are not subject to the penalty

Policy Loans

if the policy owner takes out loan against the cash value of the life insurance policy, the amount of the loan is not currently 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 Interest paid on the permanent life insurance policy loan is not tax-deductible

Cost Recovery Rule

if the policyowner does sell, surrender, or withdraw funds from he policy, the difference between what is received and what had been paid in is taxed as ordinary income

Section 1035 Exchange

internal revenue code sections 1035 allows for he exchange of existing insurance policies into another without incurring any tax liability on the interest and or investment in the current contract. These tax free exchanges known as the 1035 exchanges can be useful if another insurance policy has features and benefits that are preferred or are supuior to those found in an existing contract. One of the benefits of 1035 exchange is that the cost basis of the original policy will be transfer to the new policy in addition to any cash value. POlicywoner must be aware that surrender chargers might still apple on the existing contract and a new surrender charge period may start after the change on the newly acquired policy. Further, the new insurance contract may have higher fees and chargers than the old one which will reduce the retune or increase the cost for such thins as policy loans

Death Benefits Proceeds (Claims)

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

Annuitized Policy

the original investment ie returned in equal free installemmdns over the life expectancy of the annuitant. this portions of each payment is not taxed since they are simply a return of principal while th balance of monies received in annuity payments is the taxable gain or earning. This is taxed at ordinary income tax rates even if the gains cost basis has Benn distributed to the annuitant, the remainder of payment during the annuitant lifetime will be fully taxable as income

Life Insurance Transfer for Value Rule

the transfer for value rule was passed by Congree 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 kins of material considerations, the transfer to a new owner is return for any kind of material considerations the transfer for value rule may result in the death benefit being partially or full taxable at the time it is paid. The rule that the amount of the death benefits that exceeds the value of consideration and any additional premium paid will be taxed as ordinary income

Exclusion Ratio

the way in which taxation is computed is referred to as the exclusion ration. the IRS has tables and formulas to determine which part of the inomce benefits payment is tax free return of premium and which part is ratable

Modified Endowment Contracts

when the contracts do not pass the 7-Pay Test, they lose may tax advantages -excess premiums may be returned if done within 60 days after the end of the contract year -Singles premium life is always a MEC -If a contract is a MEC, all cash value transactions are subject to a tax and penalty -Funds are subject to 10% penalty gains withdrawn prior to 59 1/2 -Exemptins -Distrubutions made on or after 591/2 -Distrbutions made due to death or total disability

First In First Out (FIFO)

when wtithdrawing cash value life insurance policy, the amount of withdrawals up to the policy cost basis will be tax free. The cost basis is the amount of premiums paid into the policy less and dividends or withdrawals previously taken. Any withdrawals in excess of the cost basis will be taxed as ordinary income