Quiz: Taxation of Individual Life Insurance

Ben owns a $100,000 policy on his life, which sells to his younger brother, Bart, for $50,000. Bart names himself beneficiary and pays the policy's annual $1,500 premium. Four years after the sale, Ben dies, and Bart receives the policy's $100,000 death benefit. Under the transfer-for-value rule, what is Bart's taxable "gain" on the policy? A. $44,000 B. $38,000 C. $50,000 D. $6,000

A. $44,000 Bart's gain in the policy is $44,000: the $100,000 death benefit less the $50,000 purchase price and $6,000 premiums paid.

Under the life insurance transfer-for-value rule, to what extent are death benefits from a policy sold to another party considered taxable income to the new owner? A. The taxable portion equals the death benefit minus the sum of the initial purchase price and all subsequent premiums paid by the new owner. B. The taxable portion equals the death benefit minus the policy's cash value at the time of the transfer. C. The full death benefit is taxable. D. The taxable portion equals the death benefit minus the initial purchase price paid by the new owner.

A. The taxable portion equals the death benefit minus the sum of the initial purchase price and all subsequent premiums paid by the new owner. In a transfer-for-value policy, taxable gain equals the death benefit minus the new owner's cost basis, which is equal to the initial price paid for the policy by the new owner plus all subsequent premiums paid by the new owner.

Cal bought a $100,000 universal life policy ten years ago. He has paid $8,000 in premiums into the policy. He now decides to surrender the policy for its full $15,000 cash value. What amount is taxable? A. $15,000 B. $8,000 C. $7,000 D. $100,000

C. $7,000 Only the gain, which is the difference between what Cal paid into the policy and the cash value he receives, is taxable income.

According to the Health Insurance Portability and Accountability Act (HIPAA), which of the following most correctly describes how accelerated life insurance benefits are taxed? A. Accelerated benefits are not taxable as long as the insurance company certifies the insured as being terminally ill. B. Accelerated benefits are taxable unless the accelerated benefits are paid out through a viatical settlement. C. Accelerated benefits are not taxable if the insured meets the definition of being terminally ill or chronically ill. D. Accelerated benefits paid to the insured are taxable unless the insured can prove financial hardship.

C. Accelerated benefits are not taxable if the insured meets the definition of being terminally ill or chronically ill. HIPAA states that accelerated benefits paid to the insured are not taxable if certain qualifications are met. These qualifications require the insured to meet the definition of terminally ill or chronically ill.

Which of the following statements correctly describes the tax treatment of life insurance death benefit settlement options other than a lump-sum payment? A. The death benefit principal of every settlement option payment is taxable income to the beneficiary, but the interest earnings are income tax free. B. The full amount of every settlement option payment is taxable to the beneficiary. C. The death benefit principal of every settlement option payment is income tax free, but the interest earnings are taxable income to the beneficiary in the year earned. D. The death benefit principal of every settlement option payment is income tax free, and the interest earnings are tax deferred until the benefit has been fully paid out.

C. The death benefit principal of every settlement option payment is income tax free, but the interest earnings are taxable income to the beneficiary in the year earned. In general, life insurance death benefits paid to a beneficiary in a lump sum are not taxed, but if the payout option is other than a lump sum, interest earnings are taxable income to the beneficiary in the year earned.

Cash value withdrawals from a non-MEC life insurance policy are generally treated on a first-in/first-out (FIFO) basis for tax purposes, which means the first funds withdrawn are recognized as: A. accrued interest B. death benefit proceeds C. a return of premiums D. the policy's gain

C. a return of premiums In a life insurance contract, the premium payments are put into the contract first. As long as the policy is not a modified endowment contract (MEC), withdrawals are recognized first as a non-taxable return of premiums.

In a modified endowment contract, the life insurance policy's cash value grows more quickly than is permitted by the Tax Code. This results primarily from which of the following? A. the policyowner buying two or more policies and combining them B. a policy that is paid up before age 120. C. excessively large premiums being deposited into the contract during the first seven years or less D. the policy's death benefit shrinking

C. excessively large premiums being deposited into the contract during the first seven years or less This imbalance results from large amounts of premiums being deposited into the contract.

In addition to ordinary income taxation, what else is a distribution from a modified endowment contract (MEC) before age 59½ subject to? A. 10 percent premature distribution tax penalty on the policy's full death benefit B. 20 percent premature distribution tax penalty on the withdrawn amount C. 20 percent premature distribution tax penalty on the policy's full death benefit D. 10 percent premature distribution tax penalty on the withdrawn amount

D. 10 percent premature distribution tax penalty on the withdrawn amount Any distribution that a MEC policyowner includes in his or her income before age 59½ is subject to a 10 percent premature distribution tax penalty on the withdrawn amount, not the full death benefit.