Chapter 7

H has an annuity funded with after-tax contributions. So far, H has placed $10,000 into the policy and it is now worth $25,000. If H cashes out the annuity, what is H's cost basis?

$10,000

Generally, the ________ is the amount of premiums paid into the policy less any dividends or withdrawals previously taken.

Cost basis

Death Benefit Proceeds

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

Exclusion Ratio

In general, the way in which taxation of annuities is computed is referred to as the exclusion ratio. The IRS has tables and formulas to determine which part of the income benefit payment is tax-free return of premium and which part is taxable. A withdrawal or partial surrender is any amount distributed from the annuity that is not part of the annuitization process.

Cash Values

A cash value policy may experience increases in the cash value annually. Part is from the premium and part is from any interest or gains. The interest or gains are not taxable at the time they are credited to the policy.

Dividends

A participating policy's dividend consists of the amount of premium that is returned to the policyowner if the insurance company achieves lower mortality and expense costs than expected. Dividends are paid out of the insurer's surplus for that year. The dividends are not taxable since dividends are considered a return of unearned premium.

Corporate-Owned Annuities

An annuity contract owned by a non-natural person is not treated as an annuity for federal income tax purposes so the contract's gains are currently taxed as opposed to being tax deferred. In short, there are no tax benefits when an annuity is owned by a corporation.

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

Premiums

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.

Taxation

If a contract is deemed to be a MEC, then 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. Taxable distributions include partial withdrawals, cash value surrenders and policy loans (including automatic premium loans).

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 59½. This is considered a premature distribution. Distributions made on or after 59½ and distributions paid out due to death or disability are not subject to the penalty.

If a(n) ________ does not pass the 7-pay test, it will be deemed a Modified Endowment Contract (MEC).

Life insurance policy

All of the following transactions qualify for IRC Section 1035 exchange tax treatment, except:

Nonqualified tax deferred annuities may be exchanged for life insurance policies

Death Benefit Proceeds (Claims)

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

Estate Taxes and Considerations

When an individual life insurance policy is owned by the insured, the value of the death benefit may be included in the insured's estate, either intentionally or by default. The policyowner may name the estate as a beneficiary. These values will be added to the amount in the estate and potentially be subject to federal estate taxes.

Distributions at Death

When the annuitant dies during the accumulation phase of the annuity the beneficiary receiving the death benefit must pay income tax on any gain embedded in the policy at ordinary income tax rates.

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 do not constitute taxable income to the employee unless the death benefit paid for by the employer exceeds $50,000.

Generally, life insurance will be considered 'incidental' to a qualified plan if no more than what percentage of the contributions are used to pay insurance premiums?

50%

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

After-tax

Policy Loans

If a policyowner takes out a loan against the cash value of a life insurance policy, the amount of the loan is not currently taxable. This is true even if the loan is larger than the amount of the premiums paid in. 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.

Section 1035 Exchanges

Internal Revenue Code Section 1035 allows for the exchange of existing insurance policies into another without incurring any tax liability on the interest and/or investment gains in the current contract. These tax-free exchanges, known as 1035 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.

Qualified Retirement Plans

Qualified pension and profit-sharing plans were created by Congress to help employees accumulate assets for retirement and provide tax advantages for contributions made by employers. While there are generally no specific limitations on the types of assets that may be purchased to fund these plans, there are limitations on the types of benefits which may be included in a qualified plan.

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, the benefit must meet the following conditions:

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-pay whole life policy providing the same death benefit.

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. If the annuitant dies during the annuity or payout phase, the remaining value in the account will be added to the deceased annuitant's estate for valuation. However, if the annuitant was receiving income from a pure life or straight life annuity, the company keeps the balance and nothing is included in the annuitant's estate for valuation.

Individual Annuities

Tax-qualified annuities are funded with pre-tax dollars. They're also fully taxable at ordinary income rates when money is withdrawn because the premiums paid and subsequent premiums do not establish a cost basis. Non-qualified annuities are funded with after-tax dollars

Life Insurance Transfer for Value Rule

The transfer-for-value rule was passed by Congress to discourage business transfers of ownership between parties looking to take advantage of the tax free status of life insurance death benefits. If a life insurance policy is transferred to a new owner in return for any kind of material consideration, the transfer-for-value rule may result in the death benefit being partially or fully taxable at the time it is paid.

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

When a transfer of ownership has taken place