Chapter 7 - Federal Tax Considerations and Retirement Plans

Roth IRA

nondeductible tax-free retirement plan for anyone with earned income.

Defined Benefit Plan

provides employees with a fixed and known benefit at retirement, the amount of which generally 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. NOTE: could be funded by a group deferred or individual deferred annuity.

If a life insurance policy becomes a MEC, what was the cause?

the policy failed the 7 pay test.

An IRA account owner may take an early withdrawal from an individual retirement account without a penalty tax when certain qualified events occur, 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 insurance premiums. - qualified educational expenses

Learning Objectives

1. Identify taxation of premiums, cash values, policy loans and dividends as it applies to personal life insurance. 2. List the characteristics of a Modified Endowment Contract 3. Describe the taxation of group insurance premiums and proceeds 4. Recognize what constitutes a 1035 exchange 5. Define the exclusion ratio in an annuity 6. Compare a qualified and nonqualified retirement plan 7. Identify ERISA requirements 8. Compare and contrast a Traditional and Roth IRA 9. List the types of qualified retirement plans

Lightning Facts

1. Premiums for personal uses of life insurance are not tax deductible. 2. In a cash value policy, income tax on any gains is deferred until the policyowner withdraws the cash value. 3. In the event of a partial or full surrender of a cash value policy, any amount of cash value that exceeds the premiums paid (the cost basis) will be taxable as income in the year it was distributed. 4. Policy loans are not taxable at the time of distribution. 5. Interest paid to the insurer, if any, for a policy loan is not tax deductible to the policyowner. 6. A participating cash value policy may receive "dividends" from the insurance company. Dividends are paid from the insurer's surplus earnings for that year. 7. Dividends are considered by the IRS as a refund of excess premiums rather than profit or gain for the policyowner, and are not taxable as a result. 8. If dividends are left with the insurer to "accumulate at interest" , the annual interest credited to prior dividends is taxable as ordinary income. 9. The paid up additions dividend option provides for additional cash value insurance to be added to the existing insurance without evidence of insurability. 10. Death benefit proceeds from life insurance are generally received by the beneficiary income tax free. However, any interest that accrues following the death of the insured prior to the payment of the death benefit is taxable as income to the beneficiary. 11. A beneficiary who receives the policy proceeds in any manner other than a lump sum receives a combination of death benefit principal plus interest on the principal left with the insurance company. The interest is taxable, but the principal is income tax-free. 12. The Accelerated Death Benefit is a rider or provision that permits the policyowner to access the death benefit prior to the insured's death in the event the insured becomes terminally ill. 16. Premiums paid by a business for group life insurance on its employees as a benefit are tax deductible to the business. As long as the insurance amount is not more than $50,000, there is no income tax liability for the employee, even if the premium is paid in full by the employer. 17. When an employee's life insurance benefit exceeds $50,000, the amount of premium paid by the employer for the portion of the benefit in excess of 50k should be reported as taxable income to the employee, so that the entire death benefit is tax-free to the beneficiary. 18. The Modified Endowment Contract is a cash value policy that accumulates too much cash value in the first 7 years of the policy. 23. IRC 1035 permits the exchange of life insurance and annuity contracts and avoids the imposition of income tax on the cash value in the surrenders leading to the exchange. 24. 1035 exchanges include Life to Life, Life to annuity, and Annuity to Annuity. NOT Annuity to life. 25. Distributions from nonqualified annuities are taxable as to gain only. 26. Annuity benefits payable to a beneficiary upon the death of the annuitant are taxable if they are a gain embedded in the policy. 32. At age 70.5, contributions to qualified retirement plans must cease and Required Minimum Distributions must begin. 34. An IRA "rollover" occurs when some or all of the funds from an IRA or other qualified retirement plan are distributed and subsequently deposited into another IRA within 60 days of the distribution. 37. A Roth IRA is a unique plan whose contributions are not tax deductible. Qualified distributions under current tax law will be income-tax free after age 59.5 and the account has been open for at least five years. 40. A 401 k plan is a defined contribution plan for the employees of for-profit companies. Employees define their contribution amount as a percentage of income or a fixed dollar amount per payroll period, and the employer must deduct that amount from pay and forward to the plan custodian on a timely basis. 42. A TSA is a defined contribution plan for public school employees under a 403 B or a non profit organization under the internal revenue code.

Traditional IRAs

Anyone under the age of 70.5 who has earned income may open an 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.

When may an employer deduct the premiums it pays for an employee's life insurance benefit?

As long the business does not derive a direct benefit from the policy

A Roth IRA is unique for which of the following reasons?

Contributions are nondeductible and distributions are nontaxable.

TEST TIP

Distributions from a qualified retirement plan are normally fully taxable, However; portions of a qualified retirement plan may be received Tax-Free Only if the result from previously taxed contributions.

Taxation of Nonqualified Annuities: 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. During the annuity phase, the total remaining in an account is included in the deceased annuitant's estate. - this applies for all settlement options except for the pure life income option, since the company keeps any unpaid proceeds.

the federal law that governs the rights of plan participants and beneficiaries of most employer sponsored benefit plan is

ERISA

important

IRAs may be funded using mutual funds, common stock, certificates of deposit, or annuities; but not life insurance.

Section 1035 Exchanges

IRC Section 1035 allows for the exchange of existing insurance policies into another without incurring tax liability on the interest and/or investment gains in the current contract. These tax free 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. 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 - but NEVER an annuity to life insurance

TEST TIP

Know that MEC's are subject to unfavorable tax rules and consequences.

Premature Distributions

Withdrawals before age 59.5 are generally are subject to a 10% penalty tax.

Distributions

Withdrawals, knows as Required Minimum Distributions (RMDs), from the account must start by April 1 of the year following the year the owner turns age 70.5. Failure to take all or part of an annual RMD incurs a 50% penalty tax on the amount not distributed.

Example of a cost basis:

$21,000 Cash Value - $18,000 Premiums (Cost Basis)

Under ERISA, qualified plans :

- must benefit employees and beneficiaries - may not disriminate in favor of highly compensated employees

To be considered terminally ill, federal law defines a terminal illness as one which is expected to result in the person's death within how many months?

24 For the activation of an accelerated death benefit rider, and for the purpose of limiting such claims, insurance companies often define terminal illness as one which would result in death within 12 months.

7-Pay Test

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 in a 7-year whole life policy providing the same death benefit.

Taxation

If a contract is deemed to be a MEC, then any funds that are distributed are subject to a "last-in,first-out" tax treatment, rather than the normal "first in, first out" tax treatment.

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 59.5. This is considered a premature distribution.

Under what circumstance would a policy loan in a life insurance policy be taxable?

If the policy lapses or is surrendered, any loan amount in excess of cost basis is taxable

Exclusion Ratio

In general, the way in which taxation of annuities is computed is referred to as the exclusion ratio.

Federal Tax Considerations for Retirement Plans

Nonqualified retirement plans do not meet requirements of federal law to be eligible for favorable tax treatment. B/C of this, contributions to a nonqualified plan are not tax deductible. In many cases,the earnings are still tax deferred until withdrawn.

Annuity Phase

Percentage of principal to interest determines the exclusion ratio.

ERISA (Employee Retirement Income Security Act)

Qualified plans must meet the requirements of ERISA, 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.

Policy Loans

The loan taken out of the cash value in a policy is not taxable.

Rollover

The payment is made directly to the IRA owner. The owner will have 60 days to deposit check into a new IRA to avoid taxes and penalties. Only allowed once per year. A direct rollover applies when the funds are transferred from one qualified plan to the trustee of and IRA or another plan. There is no 60 day requirement.

Modified Endowment Contracts (MECs)

Under current law, if a policy is funded too quickly it will be classified as a Modified Endowment Contract or an MEC. MEC rules impose stiff penalties to eliminate the use of life insurance as a short term savings vehicle.

Life Insurance Transfer for Value Rule

When a transfer of ownership takes place through an absolute assignment which is a change of ownership, the so-called IRC Transfer for Value Rule comes into play along with what it takes to qualify for one of the exceptions. Life insurance death proceeds are income tax free to the beneficiary EXCEPT when there is a change of ownership. For the death benefit to remain tax free, it must qualify for one of the exceptions. Ex: A $500,000 policy is sold for $50,000. After the sale the new owner pays $10,000 in life insurance premiums while the insured is still alive. Upon death of the insured $60,000 of the death benefit is received income tax free to the beneficiary while $440,000 is taxable.

All of the following tax-free exchanges of life insurance and annuities are permitted except

annuity to life insurance

Distributions at death

beneficiary is subject to taxation of earnings if owner dies during accumulation phase.

Defined Contribution Plan

provides employees with a retirement benefit based on the value of the employee's account at retirement. 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

An annuitant contributed $50,000 to her nonqualified annuity, and when she annuitized the policy, the insurance company determined that, based on her life expectancy, she will reveive $100,000 in payments. If her initial monthly payment was $1,000, how much of that payment was taxable?

$500 Distributions from a nonqualified annuity are never tax-free. The initial monthly payment will never be fully taxable. $50,000 (cost basis) divided by $100,000 (expected distribution) equals 50% (.50). $1,000 x .50 = $500.

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 does 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.