Federal Tax Considerations for Life Insurance

An individual has been diagnosed with Alzheimer's disease. He is insured under a life insurance policy with the accelerated benefits rider. Which of the following is true regarding taxation of the accelerated benefits?

A portion of the benefit up to a limit is tax free; the rest is taxable income. When accelerated benefits are paid to a chronically ill insured, they are tax free up to a certain limit. Any amount received in excess of this dollar limit must be included in the insured's gross income.

During partial withdrawal from a universal life policy, which portion will be taxed?

Interest

What is the main purpose of the Seven-pay Test?

It determines if the insurance policy is a MEC. The Seven-pay Test determines whether an insurance policy is "over-funded" or if it's 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 and interest.

Which of the following is true regarding taxation of accelerated benefits under a life insurance policy?

They are tax free to terminally ill insured. When accelerated benefits are paid under a life insurance policy, they are received tax free by terminally ill insured, and tax free up to a limit for chronically ill insured.

An insured owns a life insurance policy. To be able to pay some of her medical bills, she withdraws a portion of the policy's cash value. There is a limit for a withdrawal and the insurer charges a fee. What type of policy does the insured most likely have?

Universal life Universal Life policies allow for policyholders to withdraw a limited portion of the policy's cash value. Each withdrawal, however, is usually charged, and the amount and frequency of withdrawals are usually limited.

Which of the following statements regarding the taxation of Modified Endowment Contracts is FALSE?

Withdrawals are not taxable. Any distributions from MECs are taxable, including withdrawals and policy loans. All of the other statements are true.

If $100,000 of life insurance proceeds were used in a settlement option, which paid $13,000 per year for ten years, which of the following 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).

Which of the following terms is used to name the nontaxed return of unused premiums?

Dividend The return of unused premiums is called a dividend. Dividends are not considered to be income for tax purposes, since they are the return of unused premiums.

If an insured surrenders his life insurance policy, which statement is true regarding the cash value of the policy?

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

Which of the following is NOT true regarding policy loans?

Money borrowed from the cash value is taxable. 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.

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?

$3,000 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 $3,000.

Which of the following is true regarding taxation of dividends in participating policies?

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.

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.

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

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.

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

Taxable interest will be withdrawn first and the 10% penalty will be imposed if under age 59 ½. When money is withdrawn from the annuity during the accumulation phase, the amounts are taxed on a last in first out basis (LIFO). Therefore, all withdrawals will be taxable until the owner's cost basis is reached.