Part 7: Federal Tax Consideration for Life Insurance & Annuities

List the ways in which policy owners may receive those LIVING BENEFITS from the policy

CASH VALUE INCREASE DIVIDENDS POLICY LOANS SURRENDERS

Define the TAX BASE portion of each annuity benefit payment.

The portion that is taxable is the interest earned on the principal.

List the 3 checkpoints developed to counteract the MODIFIED ENDOWMENT CONTRACTS - MECs

1. Seven-Pay Test 2. MEC vs. LIFE INSURANCE 3. DISTRIBUTIONS

What are the Federal Tax Considerations for Life Insurance & Annuities for VALUES INCLUDED IN INSURED'S ESTATE?

The death benefit or face amount of a life insurance policy may be included in the insured's TAXABLE ESTATE at death and subject to the FEDERAL ESTATE TAX.

The following are allowable exchanges:

1. A Life Insurance Policy for Another Life Insurance Policy, an endowment contract, or an annuity contract 2. An endowment contract for another endowment contract or an annuity contract; 3. An annuity contract for another annuity contract

Define the COST BASE portion of each annuity benefit payment

A portion of each annuity benefit payment is taxable and a portion is not. The portion that is nontaxable is the anticipated return of the principal paid in. This is known as the COST BASE.

TRUE or FALSE If the insured, as policy owner, assigns or transfers ownership of the policy or makes a gift of the policy within 3 years prior to his or her death, the entire face amount of the policy will be included in his or her taxable estate.

TRUE

What are the Federal Tax Considerations for Life Insurance & Annuities Settlement Options?

With SETTLEMENT OPTIONS, when the beneficiary received payments consisting of both principal and interest, the interest portion of the payments received is taxable as income.

Give scenario of Cash Surrender:

Consider the following scenario: Face amount = $300,000 Premium paid = $70,000 Total Cash Value = $100,000 If the insured surrendered $30,000 of cash value, the full $30,000 would be income tax free. If the insured took out $100,000 the last $30,000 would be taxable because the $100,000 exceeds the premiums that were paid in by $30,000.

What are the Federal Tax Considerations for Life Insurance and Annuities when it comes to CASH VALUE INCREASES?

1. Any cash value accumulations in the policy can be borrowed against by the policy owner, or may be paid to the policy owner upon surrender of the policy. 2. Cash values grow tax deferred. 3. Upon surrender or endowment, any cash value in excess of cost basis - premium payments - is taxable as ordinary income. 4. Upon death, the face amount is paid, and there is no more cash value. 5. Death benefits generally are paid to the beneficiary income tax free.

Define a ROLLOVER and discuss taxation policies of a ROLLOVER.

A ROLLOVER is a tax-free distribution of cash from one retirement plan to another. -Generally, IRA rollovers must be completed within 60 days from the time the money is taken out of the first plan. -If the distribution from the first plan is paid directly to the participant, 20% of the distribution must be withheld by the payor. -The 20% withholding of funds can be avoided if the distribution is made directly from the first plan to the trustee or administrator/custodian of the new IRA plan - THIS IS CALLED A DIRECT ROLLOVER.

What are the tax implications for corporate-owned annuities that are different from individual annuities?

Corporate-owned annuities have different tax implications than individual annuities including: -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

How does the 7-PAY TEST work to detect and classify contracts as MODIFIED ENDOWMENT CONTRACTS - MEC'S.

In a MODIFIED ENDOWMENT CONTRACT - MEC, the cumulative premiums paid during the first 7 years of the policy exceed the total amount of net level premiums that would be required to pay the policy up using guaranteed mortality costs and interest.

Generally speaking, what taxation rules apply to life insurance policies?

PREMIUMS are not tax-deductible DEATH BENEFIT 1. Tax free if taken as a lump-sum distribution to a named beneficiary 2. Principal is tax free 3. Interest is taxable if paid in installments (other than lump sum)

Compare TAXATION RULES OF TRADITIONAL IRA and the ROTH IRA

TRADITIONAL IRA ROTH IRA Contribute 100% of income up to an IRS - specified limit Excess contribution penalty is 6% Grows tax deferred Grows Tax Free -if open 5 yrs Contributions tax deductible Contr. not tax deductable (made w/ pre-tax dollars) (Made w/after-tax dollars) 10% penalty for early nonqual. Qualified distribu. cannot distributions prior to age occur until account is 59 1/2 open for 5 years & Some exceptions apply owner is 59 1/2 Distributions are taxable Distrib. not taxable Payouts must begin by 70 1/2 Payouts don't have to begin by 70 1/2.

How is the EXCLUSION RATIO used to determine the annuity amounts to be excluded from taxes?

The annuitant is able to recover the cost basis nontaxable. The cost basis is the principal amount, or the amount that was paid into the annuity, which is excluded from taxes. The rest of each annuity payment is interest that has been earned and is taxable.

True or False If the insured/policy owner possessed any one of these incidents of ownership at the time of his or her death, the entire face amount of the policy will be included in the insured's taxable estate, even though the actual proceeds were paid out to the beneficiary.

This is True

Does PERMANENT LIFE insurance provides living benefits?

Yes There are several ways in which policy owners may receive those living benefits from the policy

What income taxation is a DISTRIBUTION from an IRA subject to?

It is subject to taxation in the year the withdrawal is made. In case of an early distribution - prior to age 59 1/2, a 10% penalty for early withdrawals would not apply

What is the purpose of the SEVEN-PAY TEST?

To curtail this activity, and to determine if an insurance policy is over-funded, the IRS - internal revenue service - established what is known as the 7-PAY TEST. Any life insurance policy that fails a 7-PAY TEST is classified as a MODIFIED ENDOWMENT CONTRACT - MEC, and loses the standard tax benefits of a life insurance contract.

What are the taxation rules which apply to ROTH IRA'S?

1. Contributions are not tax deductible 2. Excess contributions are subject to a 6% tax penalty

There are essentially 3 situations that will result in life insurance being included in the insured's taxable estate. What are they?

1. INCIDENTS OF OWNERSHIP 2. ESTATE AS BENEFICIARY 3. TRANSFER OF OWNERSHIP

What are the Federal Tax Considerations for Life Insurance and Annuities when it comes to POLICY LOANS?

1. The policy owner may borrow against the policy's cash value. 2. Money borrowed against the cash value is not income taxable; however, the insurance company charges interest on outstanding policy loans. 3. Policy loans, with interest, can be repaid in any of following ways: - 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

How do MEC'S - MODIFIED ENDOWMENT CONTRACTS apply to LIFE INSURANCE?

All life insurance policies are subject to the 7-pay test, and any time there is a material change to a policy - such as an increase in the death benefit - a new 7-Pay test is required. Whether from a life insurance policy or a MEC, the death benefit received by the beneficiary is tax free.

Define MODIFIED ENDOWMENT CONTRACTS (MECs)

Following the elimination of many traditional tax shelters by the Tax Reform Act of 1984, single premium life insurance remained as one of the few financial products offering significant tax advantages. Consequently, many of these types of policies were purchased solely for purposes of setting aside large sums of money for the tax-deferred growth as well as tax-free cash flow available via policy loans and partial surrenders.

What are the Federal Tax Considerations for Life Insurance & Annuities General Rules and exceptions?

General Rule: Life insurance proceeds paid to a named beneficiary are generally free of federal income taxation if taken as a lump sum. Exception: An exception to this rule would apply if the benefit payment results from a transfer for value, meaning the life insurance policy is sold to another party prior to the insured's death.

Give an example of SETTLEMENT OPTIONS and tax concerns

If $100,000 of life insurance proceeds were used in a settlement option paying $1,000 per year for 10 years, $10,000 per year would be income tax free and $3,000 per year would be income taxable.

What are the VALUES INCLUDED IN ANNUITANT'S ESTATE?

If the annuitant died during the accumulation period, only the amount of premiums paid into the annuity will be included in the deceased annuitant's estate. If the annuity has been paid up, and the annuitant dies during the annuity period, the annuity benefits will be taxable and will be included in the deceased annuitant's estate.

How does Taxation affect the AMOUNTS RECEIVED BY BENEFICIARY?

If the owner dies before distributions have begun, the entire interest must be distributed in full on or before December 31 of the calendar year that contains the 5th anniversary of the owner's death, unless the owner named a beneficiary. If the beneficiary is named, the interest payable to the beneficiary may be distributed over the life of the beneficiary beginning not later than December 31 of the year following the owner's death. If the beneficiary is the owner's spouse, he or she may choose either to receive the distributions by December 31 of the year immediately following the owner's death or leave the money in the tax-deferred account until the calendar year in which the owner would have attained age 70 1/2. At that time, the distribution would be subject to income taxation.

Explain the SECTION 1035 of the INTERNAL REVENUE CODE

In accordance with Section 1035 of the Internal Revenue Code, certain exchanges of life insurance policies and annuities may occur as nontaxable exchanges. 1. When a policy owner exchanged 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. 2. There will be no income tax on these transactions

The term TRANSFER - OR DIRECT TRANSFER- refers what?

It 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.

Match the Permanent Life Feature to the Tax Treatment

PERMANENT LIFE FEATURE TAX TREATMENT Premiums Not Tax Deductable Cash Value exceeding Premiums paid Taxable at Surrender Policy Loans Not Income Taxable Policy Dividends Not Taxable Dividend Interest Taxable in the year earned Lump-Sum Death Benefit Not Income Taxable

Describe how Rollover and a TRANSFER from one account another work within the taxation framework?

Situations exist in which a person may choose to move the monies from one qualified retirement plan to another qualified retirement plan. However, benefits that are withdrawn from any qualified retirement plan are taxable the year in which they are received if the money is not moved properly. There are 2 ways to accomplish this: A ROLLOVER and a TRANSFER from one account to another.

TRUE or FALSE 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 her or her taxable estate.

TRUE

The following are TAX CONSIDERATIONS FOR LIFE INSURANCE AND ANNUITIES

Premiums Not Deductible -personal expense Death Benefit Not income taxable -except for interest Cash Value Increase Not taxable - as long as policy in force Cash Value Gains Taxed at Surrender Dividends Not taxable -return of unused premium; however, interest is taxable Accumulations Interest Taxable Policy Loans Not income taxable Partial Surrenders First In, First Out - FIFO*** Settlement Options - Death benefit spread evenly over income period (averaged). Interest payments in excess of death benefit portion are taxable. 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. ***FIFO applies to Life Insurance Only. Annuities follow LIFO format.

What are the certain conditions, under which the 10% penalty for early withdrawals would not apply (penalty tax exceptions)?

1. Participation is age 59 1/2 2. Participant is totally disabled 3. The money is used to make the down payment on a home - not to exceed $10,000 and usually for the first-time home buyers. 4. Withdrawals are for post-secondary education expenses 5. Withdrawals are for catastrophic medical expenses, or upon death.

What are the Federal Tax Considerations for Life Insurance and Annuities when it comes to DIVIDENDS?

1. Since dividends are a return of unused premiums, they are not considered income for tax purposes. 2. When dividends are left with the insurer to accumulate interest, the interest earned on the dividend account is subject to taxation as ordinary income each year interest is earned - whether or not the interest is paid out to the policyowner.

What are the taxation rules which apply to CONTRIBUTIONS made to traditional IRA plans?

1. Tax-deductible contributions for the year of the contribution - based on the person's income 2. Contributions must be made in "cash" in order to be tax deductible - the term cash includes any form of money, such as cash, check, or money order. 3. Excess contributions are taxed at 6% per year as long as the excess amounts remain in the IRA 4. Tax-deferred earnings - the money that accumulates in the account - are not taxed until withdrawn.

What are the Federal Tax Considerations for Life Insurance and Annuities when it comes to SURRENDERS?

1. When a policyowner surrenders a policy for cash value, some of the cash value received may be taxable as income if the cash surrender value exceeds the amount of the premiums paid for the policy. 2. When the owner withdraws cash value from the universal life policy (partial surrender), both the cash value and the death benefit are reduced by the surrender.

Define INCIDENT OF OWNERSHIP?

It is defined as any one of the rights of policy ownership, such as: 1. the right to cash value, 2. the right to change the beneficiary,-the right to obtain policy loans, 3. or the right to assign the policy.

List the various types of INDIVIDUALLY OWNED annuities

Tax-deferred Accumulation Withdrawal of Interest and Principal Taxation of Individual Retirement Annuities (IRAs) Lump-Sum Cash Surrenders Premature Distributions and Penalty Tax Distributions at Death Values Included in Annuitant's Estate

Explain TAX-DEFERRED ACCUMULATION

The cost base represents the premium dollars that have already been taxed and will not be taxed again when withdrawn from the contract. The interest accumulated in an annuity is the tax base, but the TAXES ARE DEFERRED DURING THE ACCUMULATION PERIOD

What are the taxation policies of INDIVIDUAL RETIREMENT ANNUITIES - IRA'S?

When an annuity is used to fund a traditional IRA, distributions are fully taxable if contributions were made with pretax dollars. If there are not distributions at the required age, or if the distributions are not large enough, the penalty is 50% of the shortfall from the required annual amount.

List the 4 TAXATION RULES that apply to MODIFIED ENDOWMENT CONTRACT - MEC's cash value:

1. Tax-differed accumulations 2. Any distributions are taxable, including withdrawals and policy loans 3. Distributions are taxed on LIFO basis (Last In, First Out) - known as "interest-first" rule 4. Distributions before age 59 1/2 are subject to a 10% penalty.

What are the 2 Types of ANNUITIES?

INDIVIDUALLY OWNED CORPORATE OWNED