Ch. 7 Federal Tax Considerations and Retirement plans

ERISA Qualified Plans

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

Policies that are MECs

-Single premium life insurance policy -universal and variable life

Types of exchanges the IRS will allow on a tax-free basis

-life insurance to life insurance -life insurance to an annuity -annuity to an annuity -life insurance or annuity to long term care -NEVER an annuity to life insurance

defined contribution plan

A qualified retirement plan that provides employees with a retirement benefit based on the value of the employees account at retirement. The employer, employee, or both can make contributions. This type of plan in which a certain amount or percentage of money is set aside each year by a company for the benefit of the employee.

Nonqualified Plan tax

Do not meet requirements of federal law to be eligible for favorable tax treatment. Are not tax deductible. Upon withdrawal, only the earnings are taxable. Employee contributions paid with after tax dollars (not tax deductible). Usually not funded by the employer until the employee actually retires.

Cost recovery rule

If the policy owner sells, surrenders, or withdraws funds from the policy, the difference between what is received and what has been paid in is taxed as ordinary income.

Rollover

If they payment is made directly to the IRA owner, they will 60 days to deposit the check into a new IRA to avoid taxes and penalties. This type of transaction is reported to the IRS and is only allowed once in a 12 month period. A 20% withholding of funds is required unless a director rollover occurs.

IRA Transfer

In many cases, IRA assets can be transferred directly into a new account. An IRA transfer is the movement of funds between the same type of plan, such as two IRA accounts. The money is transferred directly from one financial institution to another. Transfers are not taxable and can take place as often as desired.

Death benefit proceeds (group life)

Proceeds from this group life plan to an employees named beneficiary are received income tax free.

qualified retirement plan tax

Receive favorable tax treatment. Employer contributions are immediate tax deductible to the employer at the time the contribution is made. Contributions made by employee are tax deductible or pre tax. Entire amount of withdrawal is taxable to the employer upon distribution.

Earnings in cash value

Allowed to grow on a tax deferred basis until one of the following occurs -the policy is surrendered -policy is transferred for value. (Sold or assigned) -policy ceases to meet the IRS definition of a life insurance contract

Internal Revenue Code section 1035

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.

Cost basis

Amount of premiums paid into the policy less any dividends or withdrawals previously taken. Not subject to taxation but Any withdrawals in excess of the cost basis are taxed as ordinary.

Tax-Sheltered Annuity (TSA)

Are qualified annuity plans benefiting employees of public school under the Internal Revenue Code (IRC) Section 403(b), as well as other non profit organizations in qualified under Section 501(c)(3). Employees of nonprofit organizations may have an arrangement with the employer whereby the employer agrees with each participating employee to reduce the employees pay by a specified amount and invest it in a retirement fund or contract for the employee. Employees do not make direct payments to the retirement fund. These accounts are owned by the employee, are nonforfeitable, and will be paid upon death, retirement, or termination of the employee. Pretax and the interest earned grows tax deferred.

Simplified Employee Pension (SEP)

Are set up by a private sector company that does not offer another type of qualified plan. This plan is very popular with self employed individuals. This plan uses employer funded IRAs. The employer makes contributions and deducts the payments as business expense. All distributions to employees are taxable upon receipt.

1035 exchanges

Tax free changes that can be useful if another insurance policy has features and benefits that are preferred or are superior to those found in an existing contract.

Taxation of Annuities

Tax-qualified annuities are generally funded with pretax 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. Nonqualified annuities are generally funded with after tax dollars. If a policy is annuitized, then the original investment is returned in equal tax free installments over the payment period and are not taxed since they are simply a return of principal.

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 death benefit 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 considered taxable as ordinary income.

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.

Exclusion ratio

The way in which taxation of annuities is computed.

Savings Incentive Match Plan for Employees (SIMPLE)

A plan may be established either as an IRA or a 401(k) plan. The employers contribution must be immediately vested at 100%. This means that the employee is entitled to all the employers contributions immediately. Are only available to companies that have fewer than 100 employees and must be the only type of plan the company has available for employees. It eliminates high administrative costs.

Defined benefit plan

A qualified retirement plan that provides employees with a fixed and known benefit at retirement, the amount of which depends upon length of service and highest salary attained. The company assumes the responsibility for making sure money will be available to fund a pension for retiring workers.

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.

Surrendering a cash value life policy

Any gains are subject to federal and possibly state income tax. The gain on the surrender of a cash value policy is the difference between the gross cash value paid out, plus any loans outstanding, and the cost basis in the policy. When the policy matures, cash can be paid in a lump sum or using one of the settlement options offered by the insurer.

Tradition IRA

Anyone with taxable income may contribute to a traditional IRA. Contributions may be tax deductible unless the owner is a participant in an employer sponsored retirement plan and gross income exceeds certain thresholds.

Direct Rollover

Applies when the funds are transferred from one qualified plan to the trusteee of an IRA or another plan. While this is reportable, the income is not taxable, abs there is no 60 day requirement.

Group Term Life premiums

Are Paid by an employer and are tax deductible to the business as an ordinary and necessary business expense. Any employee paid premiums are not eligible for a tax deduction. Premiums paid by the employer in connection with group life insurance do not constitute taxable income to the employee, unless the death benefit paid for by the employer exceeds $50k. All employer paid premiums for amounts above $50k are reported as taxable income to the employee.

Premiums

Are considered a personal expense and are not deductible. They are paid with after tax dollars. This establish a cost basis in the policy for tax purposes.

When may an employer deduct premiums it pays for an employees life insurance benefit?

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

ERISA (Employee Retirement Income Security Act)

A federal law that sets minimum standards for pension plans in private industry. Does not require any employer to establish a pension plan. Only requires that those who establish plans must meet certain minimum standards.

Ex. Of Transfer-for-Value

A $500k policy is transferred to a new owner and sold for $50k. After the sale, the new owner pays $10k in life insurance and premiums while the insured is alive. Upon death of the insured $60k ($50k + $10k) of the death benefit is received income tax free to the beneficiary while $440k is taxable ($500k - $60k).

State College Tuition Plans - 529 Plans

A 529 State College Tuition Plan is operated by a state or educational institution. These plans offer tax advantages when saving for college and other post-secondary training for a designated beneficiary. Contributions are not tax deductible. However, earnings are not subject to federal tax (and typically not state tax) when used for qualified education expenses of the designated beneficiary (child or grandchild).

Dividends on life insurance

A participating insurance company's dividend consists of the mount of premium that is returned to the policyowner if the insurance company achieves lower mortality and expense costs than expected. Paid out of the insurers surplus earnings for that year.

Individual Retirement Account (IRA)

Because they are established by individualsX they are not considered "qualified plans". They have their own set of rules as described in Section 408 of the Tax Code.

Estate Taxes and Benefits Included

Benefits may be included in the insured's estate, either intentionally or by default. The policyowner may name the estate as a beneficiary, or by default, if no beneficiary is living at the time of the insured's death, the benefit will automatically be paid into the insured's estate. These values will be added to the amount in the estate and potentially be subject to federal estate taxes. If the policyowner is also the named insured, the proceeds will be added to the value of the insured's estate. It is usually recommended to name an owner other than the insured for this reason.

Estate Taxation

During the accumulation phase, if the contract owner dies, the value of the annuity is included in the owners estate for valuation. If the annuitant dies during the annuity payout phase, the remaining value in the account is added to the decreased annuitants estate for valuation. However, if the annuitant was receiving income from a Pure or Straight life annuity, the company keeps the Balance and nothing goes to the estate.

Early withdrawal without penalty

Death or permanent disability Up to $10k for the down payment on a home as a first time home buyer Medical expenses not covered or reimbursed by health insurance, or pay health insurance premiums Qualified education expenses.

Variable annuity income payments

Determining the amount of each payment that is tax free is done by dividing the investment in the contract by the total number of periodic payments expected to be received, based on the settlement option selected under the contract. The income tax due is based on the annuitants ordinary income tax rates. D

Required Minimum Distribution (RMD)

Failure to take all or part of an annual RMD results in a 50% penalty tax on the amount not distributed. Individuals must start receiving distributions by April 1st of the year after they reach age 72 to avoid paying a penalty. P

Policy loans on cash value insurance:

If a policyowner takes out a loan against the cash value of a life insurance policy, the amount is not taxable. This is true even if the loan is large than the amount of the premiums paid in. It is not taxed as long as the policy is in force. If the policy lapses the excess over cost basis becomes taxable as ordinary income. The interest paid on a permanent life insurance policy loan is not tax deductible.

Taxation on MECs

If deemed a MEC, any funds distributed are taxed on a "last in, first out" (LIFO) basis. 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 59 ½. This is considered a premature distribution. Distributions made on or after 59 1/2 and distributions paid out due to death or disability are not subject to the penalty

401(k) plan

Is a defined contribution plan for employees of for-profit companies. It is an elective deferral plan or salary reduction. Also can be profit-sharing plans, allowing an employee a choice between taking income in cash or putting the income into a qualified plan and deferring that portion of income.

Roth IRA

Is a non deductible tax free retirement plan for anyone with an earned income. Maximum annual contribution limits apply as set forth by the IRS, plus a catch up contribution for persons age 50 or older. Unlike traditional IRA, contributions are not tax deductible. As long as the account has been open for at least 5 years and the owner is at least 59 1/2, proceeds under qualified distribution are received tax free.

self-employed plans (HR-10 or KEOGH plans)

KEOGH Plans, or HR-10 Plans, are available to unincorporated sole proprietors and their eligible employees. Silent partners are not eligible. Contributions for eligible employees are mandatory and based on the percentage of contribution made by the employer for his or her own account. These contributions are deductible. Before a tax law change in 2001, Keogh Plans were a popular choice for high-income self-employed people. Today, they've been largely replaced by SEP IRAs, which have the same contribution limits but much less paperwork.

Last-In, First-Out (LIFO)

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.

Expected return on tax annuity

Part of each annuity payment that represents the cost basis is in the same proportion that the investment in the contract is to the expected return. This is affected by the settlement option chosen and is based on the total amount the annuitant can expect to receive under the contract.

Life Insurance Transfer-for-Value Rule

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. The rule states that the amount of the death benefit that exceeds the value of consideration and any additional premium paid will be taxed a ordinary income. If the transfer qualifies, the death benefit will be paid tax free.

Modified Endowment Contract (MEC)

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 dies at which point a death benefit paid income tax free. Or if they needed cash they could take a tax free lifetime loan or withdrawal. These policies were used in place of investment vehicles to avoid paying taxes. Under current law, if a policy is funded too quickly, it is classified as this. These rules impose stiff penalties to eliminate the use of life insurance as a short term savings vehicle.

Cash value policy

This policy will experience increaes in the cash value annually. Part is from the premoum and part is from any interest or gains which are not taxable at the time they are credited to the policy.

7-Pay Test

When a contract does not pass this, it is deemed a MEC. This 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 policy guidelines are met, the policy will avoid being deemed a MEC.

Premature Distributions

Withdrawals before age 59 1/2 generally are subject to a 10% penalty tax. Once funded, life insurance is not a permissible investment in the IRA.

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.

First in, First Out (FIFO)

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

Executive Bonus Plans

considered to be nonqualified plans. An executive bonus plan is one in which an employer pays the premiums on a permanent life insurance policy owned by an employee. The employer may be able to deduct salary and compensation under Section 162 of the Internal Revenue Code (IRC). Since this plan is designed to provide a salary to the employee upon retirement, the premiums within limits are tax deductible to the employer and the income is taxable to the employee when paid out. These plans are nonqualified because they are designed to discriminate in favor of highly compensated key employees. While the employer pays the initial premiums, additional funds can be deposited by the employee.