Chapter 7: Federal Tax Considerations and Retirement Plans

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

E has a $10,000 traditional whole life policy with a $4,000 cash value. Premiums paid to date are $3,500. If the policy lapses with a $4,000 loan outstanding, what amount will be taxable as income to E?

$500 (If a policy lapses with an outstanding loan greater than the premium paid in, tax must be paid on the difference. In E's case, that's $500 ($4,000 - $3,500).)

When funds are transferred from one qualified plan to the trustee of an IRA or another plan, there is a _______ day requirement.

0 (A direct rollover applies when the funds are transferred from one qualified plan to the trustee of an IRA or another plan. There is no 60 day requirement.)

If funds are prematurely withdrawn from a Modified Endowment Contract (MEC) they are subject to a _____% penalty on any gains.

10%

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

If a policyowner of a life insurance policy accidently pays in premiums in excess of the MEC guidelines, the insurer can refund the excess within ______ days of the end of the contract year.

60

What is a qualified distribution from a Roth IRA account?

As long as the account has been open for at least 5 years and the owner is at least 59½, proceeds under a qualified distribution are received tax free.

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

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

Nancy has an IRA and wants to move her funds directly from one financial institution to another while still maintaining the assets within an IRA account. How many times can she do this?

As often as she likes (This describes an IRA transfer which can be done as often as she wants.)

P is 75. P's required minimum distribution for this year is $10,000. P only withdraws $2,000. What is the consequence to P for this?

$10,000 - $2,000 = $8,000 x 50% = $4,000. (Failure to take all or part of an annual RMD incurs a 50% penalty tax on the amount not distributed.)

All employer-paid premiums for amounts above $_________ of group life insurance are reported as taxable income to the employee.

$50,000

Unless a direct rollover (transfer) occurs, a ______% withholding is required.

20%

What are Executive Bonus plans?

A nonqualified plan meant to provide salary to employee upon retirement

Are contributions to IRAs taxable?

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.

Life insurance policy premiums establish a _________ in the policy for tax purposes.

Cost Basis

True or False: Employees can make direct contributions to their Tax-Sheltered Annuities (TSAs)

False (Employees do not make direct payments to the retirement fund.)

True or False: An IRA may be funded with a life insurance policy.

False (Life insurance does not meet the IRS qualifications for funding an IRA.)

What is the Transfer for Value Rule?

If a life insurance policy (or any interest in that policy) is transferred for something of value (money, property, etc.), a portion of the death benefit is subject to be taxed as ordinary income.

When would a life insurance policy loan be subject to income taxation?

If the policy lapses when there is a policy loan outstanding which is in excess of the policy's cost basis

Which of the following distributions in a life insurance policy is taxable? A. Cash dividend from a participating policy B. Interest paid on a death benefit settlement option C. Withdrawal of cost basis D. Policy loans

B. Interest paid on a death benefit settlement option (Interest paid as part of a death benefit settlement option is taxed as ordinary income.)

What are the characteristics of a Qualified Retirement Plan? (Including: SIMPLE, SEP, KEOGH, 401(K), & 403(b) Tax-Sheltered Annuities)

Cannot discriminate Penalty tax if withdrawn before age 59 1/2 Employer contributions tax deductible as business expense Interest and earnings tax exempt year earned Employer contributions and earnings taxable to employee when received

What happens if a policy is considered to be a MEC?

Cash value transactions are subject to tax and a penalty

A Roth IRA is unique for what reasons?

Contributions are not tax deductible Qualified distributions are tax free Nonqualified distributions are taxable

Are nonqualified plans taxable?

Contributions are not tax deductible because they are paid with after-tax dollars. Upon withdrawal, only the earnings are taxable. They do not qualify for a favorable tax treatment.

How are Tax Sheltered Annuities (TSAs) contributions taxed?

Contributions are pretax and the interest earned grows tax deferred.

How are qualified plans funded?

Contributions made by employee are tax-deductible or pre-tax Employer contributions are immediately tax deductible to the employer

How are nonqualified plans paid for?

Employee contributions paid with after-tax dollars (not tax-deductible) Usually not funded by the employer until the employee actually retires

How are Executive Bonus plans paid?

Employer pays premiums on a permanent life policy on employee Employer may deduct salary and compensation

If a policyowner unintentionally pays premiums in excess of the MEC guidelines, the excess premium can be refunded by the insurer within 60 days after the ________.

End of the contract year

Are qualified plans taxable?

Entire amount of withdrawal is taxable to the employee upon distribution

What is a Savings Incentive Match Plan for Employees (S.I.M.P.L.E.)?

Established either as an IRA or a 401(k) plan. Employer contributions vested 100% immediately Must have 100 employees or less Advantage is elimination of high administrative calls

True or False: Policy loans trigger a taxable event

False

True or False: As long as the account owner is under age 59 1/2 there is no maximum contribution limit to a Roth IRA

False (Roth IRAs are subject to the same maximum contribution limits as other IRAs.)

True or False: The cash value in a Universal Life Policy is tax deductible

False The cash value is tax deferred

What exceptions allow early distribution from an IRA to be penalty free?

First time home buyers with a $10k maximum Qualified education expenses, unlimited Medical expenses not covered by Health Insurance Health insurance premiums Death or permanent disability

What are Self-Employed Plans (KEOGH Plans)?

For high income self-employed individuals Also known as HR-10 Plans Silent partners are not eligible Contributions are deductible Contributions for eligible employees are mandatory and are based on a percentage of contribution made by the employer

The exclusion ratio states that once the entire cost basis has been recovered from a non-qualified annuity income benefit payout then any further payments are __________.

Fully taxable since the excess payments must represent only earnings

Withdrawals from a non-qualified annuity prior to annuitization are taxed on a ___________ basis.

Last-in, first out (LIFO)

What determines a qualified retirement plan?

Must benefit employees and beneficiaries May not discriminate in favor of highly-compensated employees Must be approved by the IRS Have a vesting requirement

How often may a person perform a rollover from one IRA to another?

Once a year

H owns a nonqualified variable annuity that has a separate account invested in the stock market. If H withdraws funds from the annuity, the earnings on the withdrawal will be taxed as:

Ordinary Income

Chad and Sue have successfully owned and operated their bakery for 10 years and have decided to plan for their retirement. They are not incorporated and have no full-time employees, and want a qualified plan to maximize the tax advantages while at the same time not bog them down with paperwork. Which plan would be their best option?

Simplified Employee Pension (SEP)

The cost recovery rule states:

That the excess value over premiums paid is considered taxable income when withdrawn

What is the cost basis?

The amount of premiums paid into the policy less any dividends or withdrawals previously taken.

In the event that an insured receives a periodic benefit as the result of exercising the Accelerated Death Benefit Rider, what information must the insurer provide to the insured?

The amount of the accelerated payment, the remaining death benefit and cash values

Participating policy dividends become taxable as income when:

The total amount of dividends received by a policyowner exceeds the total amount of premium he/she has paid

What are the characteristics of Tax Sheltered Annuities (TSAs)?

These accounts are owned by the employee, are nonforfeitable, and will be paid upon death, retirement, or termination of the employee.

What is a 529 State College Tuition Plan?

These are not retirement plans. These plans offer tax advantages when saving for college and other post-secondary training for a designated beneficiary. Contributions aren't tax deductible and earnings aren't subject to federal tax when used for qualified education expenses.

What are 403(b) Tax Sheltered Annuities (TSAs)?

These are qualified annuity plans benefiting employees of public schools. Employees of nonprofit organizations may arrange with the employer to deduct a certain amount from each paycheck to put into a retirement fund.

Which of the following Is the reason why premiums paid on personal life insurance are not deductible?

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

Why are dividends not taxable as income when paid out to a participating policyholder?

They represent a return of a portion of the premium paid

What is a nonqualified distribution from a Roth IRA account?

This is subject to taxation of earnings and a 10% additional tax, unless an exception applies.

What is a Defined Benefit Plan?

This provides employees with a fixed and known benefit at retirement, the amount of which depends upon length of service and highest salary attained.

Why would someone 1035 exchange their existing policy?

To seek higher returns, lower costs, and/or increased benefits

If money is paid when a change of ownership in a life insurance policy takes place, this is generally known as a ____________.

Transfer for value

The Modified Endowment Contract (MEC) rules were put into place because:

Individuals were abusing life insurance policies as tax-free investment vehicles

What is the 7-Pay Test?

It compares premiums paid for the policy during the first 7 years with the net level premiums that would have been paid on a 7-year pay whole life policy providing the same death benefit. As long as the policy premium guidelines are met, the policy will avoid being deemed a modified endowment contract.

The IRS allows for 'catch-up' IRA contributions for those age _______ and older.

50

If employees elect a defined contribution plan (Ex. 401(K)), employees define their contribution amount as:

A percentage or a fixed dollar amount per payroll period. The employer deducts that amount to forward to plan custodian.

An annuity held within a traditional IRA does not provide any ____________.

Additional tax-deferral benefit

If an annuity is annuitized, then the _________ investment is recovered income tax-free over the income benefit payment period.

After-tax

What establishes a cost basis in an annuity?

After-tax contributions (Premiums are paid with after tax dollars)

What 1035 Exchange is never permitted?

Annuity to Life Insurance

Who can open an IRA?

Anyone under the age of 70½ who has earned income

How are employer paid premiums on a group life insurance plan treated for tax purposes?

As an ordinary and necessary business expense

When must the funds in an IRA be distributed?

By April 1st of the following year the owner turns age 70 1/2. Failure to take all or part of an annual RMD incurs a 50% penalty tax on the amount not distributed.

ERISA is a ________ law.

Federal

What is FIFO? What does it mean?

First in, first out When withdrawing cash from a cash value life insurance policy, the amount of withdrawals up to the policy's basis will be tax free.

What are Modified Endowment Contracts (MECs)?

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 deferred until the insured died at which point a death benefit paid income tax free.

What are Section 1035 Exchanges?

This allows for the exchange of an existing insurance policy or contract for another without incurring any tax liability on the interest and/or investment gains in the current contract.

What is the ERISA (Employee Retirement Income Security Act)?

This is a federal law that sets minimum standards for pension plans in private industry.

Withdrawals from a non-qualified annuity that is not part of an annuitization are taxed on which method?

Last-in, first-out basis (LIFO)

What is not considered a permissable investment in an IRA?

Life Insurance

If money is paid to change the ownership on a policy covering an insured who is not terminally ill, this is referred to as a(n) __________.

Life Settlement

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

How does rollover work in an IRA?

Payment is made directly to IRA owner and they have 60 days to deposit it into another IRA account to avoid taxes and penalties. A 20% withholding fee applies. --------------------------------------------OR-------------------------------------------- IRS can perform a direct roll over to another IRA account and a 20% withholding fee does not apply.

What is not taxable in a life insurance policy?

Policy loans Cash dividends Withdrawal of cost basis

How are Executive Bonus plans taxed?

Premiums are tax deductible for the employer Income paid out is taxable to the employee

A life insurance 1035 exchange can only be completed after:

Proof of insurability has been provided and accepted

What is a Roth IRA?

Roth IRA is a nondeductible tax-free retirement plan for anyone with earned income. Contributions are not tax deductible.

KEOGH plans have been largely replaced by ________ plans, which have the same contribution limits, but much less paperwork.

SEP IRA

What happens with proceeds when someone owns a traditional IRA and a Roth IRA?

The combined contributions to both cannot exceed the annual maximum IRA contribution for one IRA.

If the contribution plan is incorporated as a profit sharing plan:

The employer defines the circumstances under which profit-based contributions will be made, and contributions must generally be made in at least 3 out of 5 consecutive years.

What is a Defined Contribution Plan?

The employer, employee, or both can make contributions. Employer sets aside a certain amount or percentage each year for the benefit of the employee. The benefits are based on the value of the employee's account at retirement.

H is employed by a company that provides group life insurance. How much of the employer-paid premiums for H's $150,000 coverage, if any, is going to be reported as taxable income to H?

The premium paid for $100,000 (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)

What are Simplified Employee Pensions (SEPs) ?

These are set up by any private sector company that does not offer another type of qualified plan. Popular with self-employed Uses employer funded IRAs Taxable upon receipt at retirement

True or False: A new application is required when moving into a new life insurance policy

True (If an existing policy has a surrender charge, it is still applied. The new policy requires evidence of insurability, and new surrender charges will apply to the new policy if it has them.)

True or False: Single Premium Whole Life policies are considered to be a Modified Endowment Contract (MEC)

True (Single Premium Whole Life would always be a MEC as it would always fail the 7-Pay Test.)

What happens when a transfer of ownership over a life insurance policy occurs in regards to the proceeds?

Unless there is an exception, life insurance proceeds are income taxable

Generally, life insurance death proceeds are income tax free to the policy beneficiary, except:

When a transfer of ownership has taken place

What are premature distributions?

Withdrawals before age 59½ generally are subject to a 10% penalty tax

Any funds distributed in a Modified Endowment Contract (MEC) are subject to a ________, _________ (____) tax treatment meaning:

last-in, first-out (LIFO) That means for income tax purposes the first money out of the annuity will be considered as earnings, not principal, and will be taxed as ordinary income when withdrawn from the contract.

ERISA requires that those who establish qualified plans must meet certain ___________standards.

minimum