study chapter 7. Taxation of Personal Life Insurance

Who pays tax on personal life insurance given as a gift? Select one: a. The insurer b. The state c. The gift-giver d. The gift recipient

Life insurance given as a gift may be subject to a federal gift tax, which is paid by the giver of the gift. The correct answer is: The gift-giver

Amounts Received by Beneficiary *Settlement Options*

-Life insurance proceeds are paid to the beneficiary upon the insured's death. -Proceeds are tax-free if received in a lump sum. -Proceeds received in installments are subject to tax because the *Death Benefit id reinvested into an Annuity that grows interest.* -Each payment contains principal (the death benefit) and interest. -The interest-portion of each payment is taxable.

When a life insurance policy becomes a MEC, what are the tax consequences? Select one: a. Interest loses tax-deferred advantage. b. Premiums are no longer tax-deductible. c. Premiums do not accrue interest. d. Withdrawals and policy loans are taxed as ordinary income.

All withdrawals and surrenders from a MEC are taxable, but the interest accrued on the cash value is tax-deferred, and the death benefit is tax-free if received in a lump-sum. The correct answer is: Withdrawals and policy loans are taxed as ordinary income.

Amounts Available to Policyowner *Accelerated Benefits*

-Accelerated benefits are received income tax-free as long as the distribution is qualified. -This means that the insured is suffering a terminal illness that is expected to result in death within two years.

*Video notes*

-Personal life insurance is treated differently than business life insurance.

Endowment

An endowment policy is a whole life policy that will pay the face amount under one of two situations: 1.) if the insured is alive at the contract maturity date, or 2.) if the insured dies during the policy period. The policy cash value must equal the face amount by the end of the policy period.

Amounts Received by Beneficiary *General Rule and Exceptions*

-Generally, beneficiaries receive life insurance proceeds tax-free if received in a lump sum; however, proceeds from life insurance policies that result from a transfer of value, or were sold to another party, may be subject to taxation. -The transfer of value rule does not apply when a life insurance policy is assigned as collateral on a loan. (Collateral:A collateral assignment is the partial and temporary transfer of ownership rights to another person or entity. Synonymous with partial and conditional assignment.)

*Business Life Insurance*

-Life insurance policy premium payments are not tax-deductible as a business expense if the company is using the policy for business purposes; however, the proceeds are tax-free. -The exception to this is when a business purchases group insurance for the benefit of its employees.

Susan has a $500,000 permanent life insurance policy. She has paid $200,000 in premiums, and the policy has a cash value of $216,000. If Susan dies, her beneficiary will pay taxes on: Select one: a. $0 b. $16,000 c. $284,000 d. $500,000

Life insurance death benefits are tax-free. The cash value is included in the death benefit, so it is not taxed. The correct answer is: $0

*Taxation of Personal Life Insurance*

-As a general rule, *premiums for life insurance policies are not tax-deductible* and *proceeds from life insurance policies are tax-free if received in a lump sum.* If proceeds are received in installments, a portion of the proceeds will contain interest, which is taxable.

What is the general rule for taxation of personal life insurance? Select one: a. Premiums are paid with after-tax dollars; proceeds received in a lump-sum are received tax-free; proceeds received in installments are taxable only to the extent of interest earned. b. Premiums are paid with pre-tax dollars; proceeds received in a lump-sum are taxed; proceeds received in installments are not taxed. c. Premiums are paid with after-tax dollars; proceeds are taxed. d. Premiums are paid with pre-tax dollars; proceeds are taxable only if received in a lump-sum.

As a general rule, premiums for life insurance policies are not tax-deductible and proceeds from life insurance policies are tax-free if received in a lump-sum. If proceeds are received in installments, a portion of the proceeds will contain interest, which is taxable. The correct answer is: Premiums are paid with after-tax dollars; proceeds received in a lump-sum are received tax-free; proceeds received in installments are taxable only to the extent of interest earned.

Which of the following is true regarding the taxation of universal life insurance policies? Select one: a. Premiums are tax-deductible. b. All cash value is taxed upon withdrawal. c. Only withdrawals of premium dollars from the cash value are taxable. d. Cash value grows tax-deferred, but may be subject to taxation upon withdrawal.

Partial surrenders from a universal life policy are not taxable up to the amount of premium that makes up the cash value. Once all premiums have been withdrawn, then all withdrawals consisting of the interest portion of the cash value are subject to taxation. The correct answer is: Cash value grows tax-deferred, but may be subject to taxation upon withdrawal.

*Modified Endowment Contracts (MECs)*

-Congress and the IRS have defined life insurance with guidelines for protecting the tax advantages associated with owning a life insurance policy. -The rules are designed to prevent over-accumulation of policy funds that allow individuals to avoid taxation for investment activities under the guise of life insurance. -Modified endowment contracts are over-funded life insurance policies in which proceeds are subject to taxation.

Amounts Available to Policyowner *Cash Value Increases*

-In whole life insurance policies, premiums build cash value. -The cash value increases as interest is earned on the premiums, and grows *tax-deffered*. -The policyowner can borrow against the policy cash value. -If the policy cash value is surrendered or endows, the interest is taxable as ordinary income. -The beneficiary receives the death benefit tax-free.

All of the following are reasons the face amount of a life insurance policy may be subject to tax, EXCEPT: Select one: a. The policy's ownership has been transferred to a third party. b. The designated beneficiary is receiving the face amount in installments. c. The deceased transferred ownership of the policy within three years prior to death. d. The policy proceeds are paid out in a lump-sum.

Generally, beneficiaries receive life insurance proceeds tax-free if received in a lump sum; however, proceeds from life insurance policies that result from a transfer of value, or were sold to another party, may be subject to taxation. If proceeds are received in installments, a portion of the proceeds will contain interest, which is taxable. The correct answer is: The policy proceeds are paid out in a lump-sum.

*Taxation of Group Life Insurance*

Premiums for group life insurance paid by the employee are not tax-deductible, but the employer can deduct premiums it pays as a business expense. -Proceeds from a group life policy are tax-free if taken in a lump sum. -Proceeds taken in installments will be subject to taxes on the interest portion of the installment

*TAMRA*

Tax Reform Act of 1984. This act restricts the payout of endowment policies.

Premiums for life insurance are not tax-deductible and death benefits, received in a lump sum, are not taxable. Which of the following is taxable? Select one: a. Interest on life proceeds paid in installments b. Dividends c. Accelerated benefits d. Policy loans

The interest portion of installment benefits is taxable. Dividends are considered a return of premium overcharges. If an insured is terminally ill, accelerated benefits are tax-free. Policy loans are considered a debt against a policy. The correct answer is: Interest on life proceeds paid in installments

Amounts Available to Policyowner *Surrenders*

Upon policy surrender, any cash value greater than the amount of premiums paid in is subject to tax. Example: Tom surrenders his whole life insurance policy with total cash value $200,000; however, he has only paid $110,000 of premiums. The additional $90,000 is taxable.

A policy loan on a whole life policy is: Select one: a. Not taxable b. Taxable c. Tax-deferred d. Taxable if not repaid prior to policy maturation

Policy loans are not taxable. The correct answer is: Not taxable

Amounts Available to Policyowner *Policy Loans*

Policyowners may take out a loan against their life insurance policy cash value. -The borrowed money is not taxable. -The insurer will charge interest on loans that have not been repaid. -Loans are repaid or recovered upon policy surrender or maturity.

Amounts Available to Policyowner *Divisible Surplus and Dividends* -Dividends = Not Taxable -Interest Earned on Dividends = Taxable

-Divisible surplus is the amount of earnings paid out after the insurance company sets aside funds required to cover contractual obligations, operating expenses, contingencies (such as worsening mortality or economic conditions), and general business purposes. -Divisible surplus funds are the result of the overpayment of premiums and are distributed to policyholders through the issuance of dividends. -Because these dividends are considered a return of overcharged premiums, they are considered not taxable because premiums are paid with after-tax dollars. -Interest earned on dividends is taxable income.

Modified Endowment Versus Life Insurance: Seven-pay Test; *Distributions*

-Modified endowment contracts are subject to the last in, first out rule which means when a withdrawal from a modified endowment contract is made, the first dollars received are interest, and as such are taxable as ordinary income. -Furthermore, if withdrawals are made prior to the policyowner reaching the age of 59½, the IRS assesses a 10% penalty tax on the interest. -Distributions from a normal life insurance policy are only taxable up to the amount in excess of premium payments. -Under a modified endowment contract, all withdrawals and surrenders are taxable. -Cash value builds tax-deferred, and the death benefit is tax-free to the beneficiary if received in a lump sum.

Modified Endowment Contracts (MECs); *Modified Endowment Versus Life Insurance: Seven-pay Test*

-To determine whether a life insurance policy is a modified endowment contract, the IRS developed the seven-pay test under TAMRA, the Technical and Miscellaneous Revenues Act. -To pass the test, the premiums paid during the first seven years of the policy may not exceed the total amount of level annual premiums that would pay-up the policy in seven years. -If the policy fails the seven-pay test, it is considered a modified endowment contract. -If the policy death benefits are increased, the policy undergoes an additional seven-pay test.

Which type of life insurance policy allows an employer to deduct premium payments as an ordinary business expense for tax purposes? Select one: a. Key employee b. Split-dollar plan c. Group life insurance d. Business continuation agreement

Life insurance policy premium payments are not tax-deductible as a business expense if the company is using the policy for business purposes; however, the proceeds are tax-free. The exception to this is when a business purchases group insurance for the benefit of its employees. The correct answer is: Group life insurance

How are personal life insurance dividends taxed? Select one: a. Interest earned on dividends is considered taxable income. b. Dividends are considered a return of overcharged premium. c. Dividends are not taxable because premiums are paid with after-tax dollars. d. All of the above

Dividends are considered a return of overcharged premium, and are not taxable because premiums are paid with after-tax dollars. Interest earned on dividends is taxable income. The correct answer is: All of the above

Amounts Received by Beneficiary *General Rule and Exceptions*

Example: Bob has a $700,000 whole life policy. He has paid $500,000 in premiums and the policy has a cash value of $470,000. If Bob dies, how much in taxes will his beneficiary pay? Remember that life insurance death benefits are tax-free if received in a lump sum. The cash value is part of the death benefit, and is, therefore, not taxable. Bob's beneficiary will not pay taxes on any part of the $700,000 death benefit.

Which of the following statements best describes how cash value in a life insurance policy is taxed? Select one: a. Cash value grows tax-free. b. Cash value does not earn interest and is, therefore, not taxable. c. If the policy cash value is surrendered, the interest earned on the cash value is taxable as ordinary income. d. None of the above

In whole life insurance policies, premiums build cash value. The cash value increases as interest is earned on the premiums, which grows tax-deferred. The policyowner can borrow against the policy cash value. If the policy cash value is surrendered or endows, the interest is taxable as ordinary income. The correct answer is: If the policy cash value is surrendered, the interest earned on the cash value is taxable as ordinary income.

Which of the following is generally true regarding premiums for individually-purchased life insurance and annuities? Select one: a. They are tax-deductible. b. They are not tax-deductible. c. Only life insurance premiums are tax-deductible. d. Only annuity premiums are tax-deductible.

Individual life insurance and annuities are purchased with after-tax dollars. Premiums generally cannot be deducted from taxes. The correct answer is: They are not tax-deductible.