Federal Tax Considerations for Life Insurance & Annuities

What term is used to name the non-taxed return of unused premiums?

Dividend

If an insured surrenders his life insurance policy, what happens to the cash value of the policy in regard to taxes?

It is only taxable if the cash value exceeds the amount paid for premiums.

If taken as a lump sum, life insurance proceeds to beneficiaries are passed

Free of federal income taxation; 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.

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?

$3000; 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 $3000.

A policyowner cancels his life policy but instructs the insurance company to transfer the cash value of his policy to an annuity. This nontaxable transaction is called

1035 exchange; In accordance with Section 1035 of the Internal Revenue Code, certain exchanges of life insurance policies and annuities may occur as nontaxable exchanges.

What is the penalty for IRA distributions that are below the required minimum for the year?

50%; If there are no 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.

If a life insurance policy develops cash value faster than a seven-pay whole life contract, it is

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. It loses the benefits of a standard life contract.

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 not taxable. Policy loans can be repaid at any time, including surrender and death. An insurer can charge interest on outstanding policy loans.

Describe the taxation of dividends in participating policies

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

An IRA uses immediate annuities to pay out benefits; the IRA owner is nearly 75 years old when he decides to collect distributions. What kind of penalty would the IRA owner pay?

50% tax on the amount not distributed as required

Life insurance death proceeds are

Generally not taxed as income.

Death benefits payable to a beneficiary under a life insurance policy are generally

Not subject to income taxation by the federal government

What method is used to determine the taxable portion of each annuity payment?

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.

What happens to the taxation of an annuity when money is withdrawn during the accumulation phase?

Withdrawn amounts are taxed on a last in, first out basis (LIFO); 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.

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 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; Any distributions from MECs are taxable, including withdrawals and policy loans. All of the other statements are true.

What is the main purpose of the seven - pay test?

It determines if the insurance policy is an MEC; the seven-pay test determines whether an insurance policy is overfunded or if it is a modified endowment contract. In other words, the cumulative premiums paid during the first seven years of a policy must not exceed the total amount of net level premiums that would be required to pay the policy up using guaranteed mortality costs & interest.

Which of the following is NOT an allowable 1035 exchange? A. A life insurance policy is exchanged for an annuity. B. A whole life insurance policy is exchanged for a term insurance policy. C. A whole life insurance policy is exchanged for a Universal life insurance policy. D. An annuity is exchanged for another annuity.

B; The key is that the exchange may not be from a less tax-advantaged contract to a more tax-advantaged contract. "Same to same" is acceptable.

What type of annuity activity will cause immediate taxation of the interest earned?

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

During the accumulation period of a nonqualified annuity, what are the tax consequences of a withdrawl?

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

Describe Taxation during the accumulation period Of an annuity:

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.

What will happen if a policy owner transfers or gives away a life insurance policy within three years prior to his death?

The entire face amount of the policy will be included in his taxable estate

If an immediate annuity is purchased with the face amount at death or with the cash value at surrender, this would be considered a

Settlement option

If $100,000 of life insurance proceeds were used in a settlement option, which paid $13,000 per year for ten years, how much would be taxable annually?

$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).

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

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

An applicant buys a nonqualified annuity, but dies before the starting date. For which of the following beneficiaries would the contract's interest NOT be taxable? A. Annuitant B. Spouse C. Charitable Organization D. Dependents

B; 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.

An insured has a Modified Endowment Contract. He wants to withdraw some money in order to pay medical bills. What will happen?

He will have to pay a penalty if he is younger than 59½; All withdrawals are subject to taxation on a LIFO basis, and if withdrawals are made earlier than the age of 59½, a 10% penalty is imposed.

When contributions to an immediate annuity are made with before-tax dollars, what happens to the distributions?

Distributions are taxable; Distributions must begin no later than age 70½ in order for the annuitant to avoid penalties. The penalty is 50% of the shortfall from the required annual amount.

An IRA uses immediate annuities to pay out benefits; The IRA owner is nearly 75 years old when he decides to collect distributions. What kind of penalty would the IRA owner pay?

50% tax on the amount not distributed as required; when immediate annuities are used to pay I RA benefits, distributions must begin no later than age 70 1/2 in order for the annuitant to avoid penalties. The penalty is 50% of the shortfall from the required annual amount.

When would life insurance policy proceeds be included in the insured's taxable estate? A. When there are any incidents of ownership at the time of death B. If the insured's spouse is the policyowner C. If the insured transfers ownership of the policy or makes a gift of the policy 5 years prior to his or her death D. When the beneficiary is named in the policy

A; If the insured were the owner of the policy at the time of death or possessed any incidents of ownership at the time of death, the value of the policy will be included in the insured's taxable estate. If the insured, as policyowner, 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.

In life insurance policies, cash value increases

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.

An insured had paid only part of her total number of IRA premiums before she died. What effect will this have on the insured's estate?

If a person dies before paying all of IRA premiums, only the amount paid would be included in the estate; the remaining premium amounts would not be deducted.

An annuitant dies before the effective date of a purchased annuity. Assuming that the annuitant's wife is the beneficiary, what will occur?

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.

What is the penalty for IRA distributions that are below the required minimum for the year?

If there are no distributions at the required AJ, where is the distributions are not large enough, the penalty is 50% of the shortfall from the required annual amount

When a beneficiary receives payments consisting of both principal and interest portions, which parts are taxable as income?

Interest only

What part of the internal revenue code allows an owner of a life insurance policy or annuity to exchange or replace their current contract with another contract without creating adverse tax consequences?

Section 1035 policy exchange

What method is used to determine the taxable portion of each annuity payment?

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. The portion that is taxable is the actual amount of payment, less the expected return of the principal paid in.

If contributions are made with before-tax dollars, contributions to an immediate annuity are

fully taxable; Distributions must begin no later than age 70½ in order for the annuitant to avoid penalties. The penalty is 50% of the shortfall from the required annual amount.

If an IRA annuitant pays the entire fund's premiums before her death, what effect will this have on her estate when she dies?

the entire value of the premiums and benefits would be included in the gross estate; If only part of the premiums were paid, the partially paid amount would be directed to the gross estate.