Chapter 7- Taxation of Personal Life Insurance

Cash Value facts:

-cash value in policy increase annually. -combo of premium paid into policy and accumulated interest -interest is not taxable -The interest earnings in the cash value grow on a tax-deferred basis until the policy is surrendered, sold, transferred for value, or matures. -cash withdrawals are taxed based on FIFO

Qualified plan employer contributions are tax deductible when _________. A They are made B The employee retires C The employee dies D The employee makes a contribution

A. They are made ** Employer contributions are immediately tax deductible.

Nonqualified plan characteristics?

Employee contributions paid with after-tax dollars (not tax-deductible) Upon withdrawal, only the earnings are taxable Usually not funded by the employer until the employee actually retires

what are the ERISA qualified plan standards?

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

A qualified plan pre-mature withdrawal tax penalty can be waived in all of the following circumstances, except: A Buying a first vacation home B Qualified educational expenses C Disability D Death

A

Regarding an accelerated death benefit, a physician must give a prognosis of ___ months or less life expectancy for the named insured. A 24 B 12 C 18 D 6

A. 24

Penalties on 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 -Funds are subject to a 10% penalty on gains withdrawn prior to age 59 ½. This is considered a premature distribution. Distributions made on or after 59 ½ and distributions paid out due to death or disability are not subject to the penalty.

Tax on policy loans?

As long as policy is in force, loan is not taxable. if policy lapses, it will be taxed based on ordinary income. -Interest paid on policy loan is not tax deductible.

Contributions to a nonqualified plan are: A Fully tax-deductible B Tax-deductible up to $50,000 C Not tax-deductible D Partially tax-deductible

C. Not tax-deductible

A qualified pension plan must meet ___________ requirements. A COBRA B SEC C OSHA D ERISA

D. ERISA A qualified plan must meet the requirements of the Employee Retirement Income Security Act (ERISA).

The life insurance policy cost basis consists of: A The cash value of the policy B The dividends received C The net amount at risk D The premiums paid in

D. The premiums paid in

Taxation on modified endowment contracts (MECs)?

If a contract is deemed to be a MEC, any funds that are distributed are subject to a "last-in, first-out" (LIFO) tax treatment, rather than the normal "first-in, first-out" tax treatment. This means that all withdrawals taken from the policy will be considered earnings and taxed as ordinary income. Once the amount withdrawn equals the amount of earnings, future withdrawals are considered part of the cost basis and are paid income-tax free. Taxable distributions include partial withdrawals, cash value surrenders, and policy loans (including automatic premium loans).

Distributions that are income tax free?

Lump sum death benefit paid to a beneficiary Policy loan from an in-force policy Group life insurance death benefit proceeds (lump sum) Policy dividend that is less than the premium paid Qualified accelerated death benefit

What is ERISA?

Employee Retirement Income Security Act 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

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? A The premium paid for $75,000 B The premium paid for $100,000 C The premium paid for $50,000 D Zero

B. 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. All employer paid premiums for amounts above $50,000 are reported as taxable income to the employee.

To be a qualified accelerated death benefit it must meet all of the following criteria, except: A The amount of the benefit must at least be equal to the present value of the reduced death benefit remaining after payment of the accelerated benefit B The benefit amount cannot exceed the lesser of $50,000 or 7.5% of AGI C The insurer provides a monthly report to the insured showing the amount paid and the amount of benefit remaining in the life insurance policy D A physician must give a prognosis of 24 months or less life expectancy for the named insured

B. The benefit amount cannot exceed the lesser of $50,000 or 7.5% of AGI. **To be a qualified accelerated death benefit the benefit must meet the following conditions: a physician must give a prognosis of 24 months or less life expectancy for the named insured, the amount of the benefit must at least be equal to the present value of the reduced death benefit remaining after payment of the accelerated benefit, and the insurer provides a monthly report for the insured showing the amount paid and the amount of benefit remaining in the life insurance policy.

All of the following are characteristics of a qualified retirement plan, EXCEPT: A Employee contributions are either pre-tax or tax deductible B Employer contributions are immediately tax deductible to the employer C Employers in private industry are required to establish pension plans D The penalty for premature distributions may be waived for death, disability, qualified education costs, medical expenses and first -time homebuyers

C. Employers in private industry are required to establish pension plans **Qualified retirement plans receive favorable tax treatment, such as deductible premiums to the employer, pre-tax or deductible premiums to the employee, and waived penalties for the listed situations. ERISA is a federal law that sets minimum standards for employers who establish pension plans in private industry, but does not require employers to establish a plan.

Clayton is asking his life insurance producer about any potential taxation issues related to his $100,000 personal Whole Life policy. All of the following are TRUE, except: A Upon surrender of the policy, he will be taxed on any amount by which the cash value exceeds the cost basis (premiums paid) of the contract B Since his policy is a personal policy, he cannot deduct the premiums he pays for the policy C The interest that he pays on policy loans is tax-deductible D Annual increases in the policy's cash value are not taxable at the time they are credited to the policy

C. The interest that he pays on policy loans is tax-deductible **The interest on policy loans is not tax-deductible.

Which of the following is the reason why premiums paid on personal life insurance are not deductible? A They are considered to produce a guaranteed source of income B It makes the deductibility of employer-paid premiums more attractive C They rarely exceed 10% of a taxpayer's AGI D They are considered a personal expense

D. 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.

When are dividends taxed?

Dividends are paid out of the insurer's surplus for that year. The dividends themselves are not taxable, since dividends are considered a return of unearned premium. When dividends are left on deposit with the insurance company, interest earned on dividends is taxable as ordinary income in the year earned. When the dividend received exceeds the total premium paid for the life insurance policy, the excess dividends are then considered taxable income.

Taxation on premiums paid by employer and employee?

ER: Tax deductible to business as ordinary business expense. EE: not eligible for tax deduction. Employer paid premiums in connection with group life insurance do 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.

Qualified plan characteristics?

Entire amount of withdrawal is taxable to the employee upon distribution Must meet ERISA minimum standards Contributions made by employee are tax-deductible or pre-tax

Taxation on Qualified Plans?

Favorable tax treatment Employer contributions are immediately tax deductible to the employer at the time the contribution is made. These contributions are not taxable to the employee until withdrawn. Employee contributions are either pretax or tax deductible. Distributions taken prior to 59 ½ are subject to taxation and a 10% penalty. The penalty may be waived for death, disability, qualified education costs, medical expenses, first-time home buyers and substantial equal payments over life expectancy. Because most qualified plans defer taxes, retirees must begin taking taxable required minimum distributions at age 70 ½. There is a 50% tax penalty if these minimum withdrawals are not taken. Upon withdrawal, the entire amount received is taxable as ordinary income.

Nonqualified plans?

Nonqualified plans are not required to meet ERISA requirements and are not eligible for the same favorable tax treatment. Nonqualified plans do not have vesting requirements and in many cases are not funded by the employer until the employee actually retires. It is possible that the employee may lose retirement benefits if the employer goes out of business. Contributions to a nonqualified plan are paid with after-tax dollars and are not tax deductible. In many cases, the earnings are still tax deferred until withdrawn. Upon withdrawal, only the earnings are taxable.

The only time a policy loan is taxable is in which of the following situations? A Having the policy lapse with a loan outstanding in excess of cost basis B Borrowing the entire cash value C Borrowing more than the premiums paid in D Borrowing less than the cash value

A. Having the policy lapse with a loan outstanding in excess of cost basis. **The loan is not taxed as long as the policy is in force. If the policy lapses with a loan outstanding, the excess over cost basis becomes taxable as ordinary income.

Under the Modified Endowment Contract rules the 7-Pay Test is defined as: A The least amount of premium required to be paid in the first 7 years to maintain the policy to age 70 B The comparison of premiums paid during the first 7 years with the net level premiums that would have been paid on a 7 year pay whole life of the same death benefit C Any life insurance policy that endows in 7 years D The cash value at the end of year 7 exceeds the total premiums paid

B. The comparison of premiums paid during the first 7 years with the net level premiums that would have been paid on a 7 year pay whole life of the same death benefit. **A MEC occurs at any time within the first seven years of a policy (or of a material change to a policy, such as a death benefit increase or decrease) if the sum of premiums paid exceeds the amount of premiums that would be paid in a 7-pay contract.

F has a $100,000 face amount term life policy for which F paid $10,000 in premium to date. F dies and the benefit is paid out to G, the beneficiary. What amount of the death benefit received is taxable as income to G? A $90,000 B Nothing C $50,000 D $100,000

B. Nothing **Lump sum death proceeds are not taxable as income to a named beneficiary.

All of the following statements regarding a Modified Endowment Contract are correct, EXCEPT: A If a policy is deemed a MEC, the owner has 7 years to receive a refund of excess premiums and remove the MEC status B Distributions on gains withdrawn from a MEC prior to age 59 1/2 are subject to a 10% penalty in addition to taxation C Distributions received from a MEC are subject to a LIFO tax treatment D A policy that fails the 7-pay test will be deemed a MEC

A. If a policy is deemed a MEC, the owner has 7 years to receive a refund of excess premiums and remove the MEC status. **A policy that does not pass the 7-Pay Test will be deemed a Modified Endowment Contract for the life of the contract. A policy can avoid being deemed a MEC if the policyowner receives a refund of excess premiums by the insurer within 60 days of the end of the contract year.

Which of the following scenarios will trigger an income tax due? A Interest earned on dividends left on deposit with the insurer B Receiving a participating policy's cash dividend C Cancelling the policy during the free look period D Taking out a policy loan in an amount greater than the total premiums paid in

A. Interest earned on dividends left on deposit with the insurer. **While the dividend is free from income tax the interest earned on the dividend is subject to tax.

If a(n) ________ does not pass the 7-pay test, it will be deemed a Modified Endowment Contract (MEC). A Life insurance policy B Annuity C Endowment contract D Viatical settlement

A. Life Insurance Policy

All of the following regarding policy loans are true, except: A Policy loans are taxable if the policy remains in effect and the amount borrowed exceeds the premiums paid B The interest on a policy loan is not deductible C Policy loans cannot exceed the amount in the cash value D The policy loan is not taxable so long as the policy remains in force

A. Policy loans are taxable if the policy remains in effect and the amont borrowed exceeds the premiums paid **If the policy lapses with a loan outstanding, the excess borrowed over the premium paid becomes taxable as ordinary income.

Which of the following statements is correct regarding an employer's ability to deduct the premiums it pays for an employee's life insurance benefit? A Premiums are deductible as long as the business does not derive a direct benefit from the policy B Employers can always deduct the premiums it pays for an employee's life insurance benefit C Premiums can be deductible if the business does not receive more than 50% of the death benefit D An employer cannot ever deduct premiums it pays for an employee's life insurance benefit

A. Premiums are deductible as long as the business does not derive a direct benefit from the policy. **As long as the insurance death benefit is not payable to the employer when an employee dies, the premiums paid for the life insurance are deductible to the business.

A permanent policy is surrendered for its cash value, and that sum is greater than the amount of premiums paid in. How is the excess taxed? A Taxed as ordinary income B Taxed as a short term capital gain C Taxed as long term capital gain D No tax is due

A. Taxed as ordinary income **Upon surrender, any equity (i.e., amount above total premiums paid) is taxed as ordinary income. The premiums paid are also referred to as 'cost basis.'

Joe had $500,000 of life insurance at work. He has an additional $40,000 life insurance policy the company purchased on all employees. His wife is the primary beneficiary and their four children are contingent beneficiaries. Upon Joe's death, what are the tax consequences to his beneficiaries? A The $540,000 lump sum proceeds will be received income tax-free B The $40,000 will be taxed since the premium was tax-deductible by the employer C All premiums paid may be deducted from the face value before taxation D $460,000 is income taxable to the recipient

A. The $540,000 lump sum proceeds will be received income-tax free **The death benefit (face amount) of both individual and group policies received in a lump sum by a named beneficiary(s) is income tax-free.

All employer-paid premiums for amounts of group life insurance over $__________ are reported as taxable income to the employee. A $25,000 B $50,000 C $100,000 D $150,000

B. $50,000 **Premiums paid for death benefits exceeding $50,000 are taxable as income to the employee for the year in which the premium was paid.

All of the following are TRUE regarding non-qualified retirement plans, except: A Earnings can be tax deferred until withdrawn B Contributions are immediately tax deductible C Contributions are not tax deductible D Upon withdrawal only the earnings are subject to taxation

B. Contributions are immediately tax deductible **Because the plan is non-qualified many of the tax benefits are not available, such as tax deductibility of contributions.

All of the following are TRUE regarding qualified plans, except: A Employer contributions are immediately tax-deductible B Plans can discriminate in favor of highly compensated employees C Distributions taken prior to age 59 1/2 are subject to tax and a tax penalty D Employer contributions are not taxable to the employee until withdrawn

B. Plans can discriminate in favor of highly compensated employees

Death benefits are paid to the estate of the policyowner/insured in which of the following situations? A The primary beneficiary is a minor B The beneficiary is the estate C The primary beneficiary is the deceased's spouse D The contingent beneficiary has outlived the primary beneficiary

B. The beneficiary is the estate **If the beneficiary is listed as the estate, then upon death of the insured that is where the funds will end up.

Cash values within an ordinary straight whole life insurance policy _______ over time. A Decrease B Remain constant C Increase D Vary

C. Increase **Cash values increase over time as premium is paid in and interest is reflected in the cash values shown in the policy's nonforfeiture table.

Distributions that are Taxable?

Death benefits included in an insured's estate Withdrawals, cash surrenders, and policy loans distributed from a MEC up to an amount equal to the earnings Interest earned on policy dividends Interest received from a life insurance death benefit settlement option Life insurance cash withdrawals or surrenders that exceed the cost basis

What are premiums?

For individuals, premiums are considered a personal expense and are not deductible. They are paid with after-tax dollars. All contributions made with after-tax dollars are considered to be the policy's cost basis for tax purposes.

Taxation on accelerated death benefits?

The payment of an accelerated death benefit is tax free to a recipient if the benefit payment is qualified. To be a qualified benefit, it must meet the following conditions: -A physician must give a prognosis of 24 months or less life expectancy for the named insured -The amount of the benefit must at least be equal to the present value of the reduced death benefit remaining after payment of the accelerated benefit -The insurer provides a monthly report for the insured showing the amount paid and the amount of benefit remaining in the life insurance policy

What is the 7-pay test?

When a contract does not pass the 7-Pay Test, it will be deemed a MEC. The 7-Pay Test is 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 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. If a policyowner pays premiums in excess of the guidelines, the excess premium can be refunded by the insurer within 60 days after the end of the contract year. Since a single premium life insurance policy clearly does not pass the 7-Pay Test, it will automatically be deemed a MEC. The other types of policies that could be classified as MECs are flexible premium policies such as Universal and Variable Universal Life. The flexible premium feature allows the owner to pay premiums on their own schedule. Once a policy is classified as a MEC, it will maintain that classification for the life of the policy. The overfunding cannot be undone in future years.

C paid $20,000 in premiums into a $100,000 universal life insurance policy. The accumulated cash value was $35,000 when C received a cash withdrawal of $30,000. How much of the cash withdrawal was taxable? A $10,000 B $30,000 C $0 D $20,000

A. $10,000 **The cost basis in this scenario is $20,000. Only the amount withdrawn that exceeds the cost basis is taxable. Therefore, of the $30,000 withdrawn, $10,000 is taxable.

An insured has contributed $12,000 in premiums toward a universal life policy. She decides to cancel the policy and take the cash value of $15,000. What are the tax consequences of this distribution? A The full $15,000 is tax deferred B $12,000 is a return of after tax dollars (i.e. cost basis), $3,000 is taxable as long-term capital gain C $12,000 is a return of after tax dollars (i.e. cost basis), $3,000 is taxable as ordinary income D The distribution at surrender is tax free

C. $12,000 is a return of after tax dollars (ie: cost basis), $3,000 is taxable as ordinary income **Upon surrender of a permanent life insurance contract, cash value received is taxable to the extent it exceeds total premium paid (i.e. CSV - cost basis = equity). The equity is taxed as ordinary income.

Which of the following policies would be deemed a MEC? A 10-pay Whole Life B Universal Life C Single Premium Whole Life D Variable Universal Life

C. Single Premium Whole Life **Since a single premium life insurance policy clearly does not pass the 7-pay test, it will automatically be deemed a MEC.

Tax on death benefit proceeds?

Death benefit or face amount not considered taxable when paid as a lump sum to a named beneficiary. -If settlement option is used, any interest or earnings component of each payment would be taxable as ordinary income.

Taxation on death benefit proceeds?

Death benefit proceeds from a group life insurance plan to an employee's named beneficiary are received income tax free.

What is the Modified Endowment Contracts (MECs)?

Prior to 1988, ppl could place large lump sums into policy tax free. -these policeis were used in place of investment vehicles to avoid paying taxes. -Under current law, if a policy is overfunded in the early years (funded too quickly) it will be classified as a Modified Endowment Contract (MEC). MEC rules impose stiff penalties to eliminate the use of life insurance as a short term savings vehicle.

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? A The amount of the accelerated payment, the remaining death benefit and cash values B The amount of taxable income that they will be reporting to the IRS C The life expectancy of the insured on a semi-annual basis D Verification and update of the policy ownership and beneficiary designations

A. The amount of the accelerated payment, the remaining death benefit and cash values **The Accelerated Death Benefit Rider advances a terminally ill insured a portion of the death benefit.

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. **Policy loans, cash dividends, and withdrawal of cost basis are not subject to taxation. Interest paid as part of a death benefit settlement option is taxed as ordinary income.