Chapter 7
What are 401(k) plans?
- A 401(k) Plan is a defined contribution plan for employees of for-profit companies - It is an elective deferral plan or salary reduction
To be a qualified accelerated death benefit, it must meet the following conditions:
- A physician must give a prognosis to the named insured of a life expectancy of 24 months or less - 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
An IRA account owner may take an early withdrawal without a penalty tax when certain qualified events occur, such as:
- Death or permanent disability - Up to $10,000 for the down payment on a home as a first-time home buyer - Medical expenses not covered or reimbursed by health insurance, or to pay health insurance premiums - Qualified educational expenses
Taxation of Annuities: estate taxes
- 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 payout phase, the remaining value in the account is added to the deceased annuitant's 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 into the annuitant's estate for valuation.
Traditional IRAs: Required Minimum Distributions (RMDs)
- 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.
Life Insurance Transfer-for-Value Rule
- If a life insurance policy is transferred to a new owner in return for any kind of material consideration, the transfer-for-value rule partially removes the tax-exempt status of a life insurance policy. The rule states that the amount of the death benefit that exceeds the value of consideration and any additional premium paid will be taxed as ordinary income. - If the transfer qualifies as an allowable exception to the rule, the death benefit will be paid tax free
Contribution characteristics for a 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 who are primarily investors and are not involved in the daily operations are not eligible. - Contributions for eligible employees are mandatory and based on the percentage of contribution made by the employer for their own account. These contributions are deductible.
Types of exchanges the IRS will allow on a tax-free basis are from:
- Life insurance to life insurance - Life insurance to an annuity - Annuity to an annuity - Life insurance or annuity to long-term care - But NEVER an annuity to life insurance When moving from an existing life insurance policy to a new life insurance policy as part of a 1035 exchange, the new life insurance policy will be issued only after a new application for coverage is received and the policy is issued and accepted.
qualifications for ERISA ((Employee Retirement Income Security Act) qualified plans:
- Must benefit employees and beneficiaries - May not discriminate in favor of highly-compensated employees - Must be approved by the IRS - Have a vesting requirement that eventually gives the employee full ownership of the employer's contributions to the plan after a specified number of years
Any earnings in the cash value are allowed to grow on a tax-deferred basis until one of the following events occurs:
- The policy is surrendered - The policy is transferred for value (sold or assigned) - The policy ceases to meet the IRS definition of a life insurance contract
categories of qualified retirement plans:
- defined benefit plan - defined contribution plan
Who are 401(k) plans for?
A 401(k) Plan is a defined contribution plan for employees of for-profit companies
what does a defined benefit plan do for employees?
A defined benefit plan provides employees with a fixed and known benefit at retirement, the amount of which depends upon length of service and highest salary attained
what does a defined contribution plan provide for an employee?
A defined contribution plan provides employees with a retirement benefit based on the value of the employee's account at retirement
direct rollover:
A direct rollover applies when the funds are transferred from one qualified plan to the trustee of an IRA or another plan - While this is reportable, the income is not taxable, and there is no 60-day requirement.
which taxes is a nonqualified distribution from a Roth IRA subject to?
A nonqualified distribution is subject to taxation of earnings and a 10% additional tax, unless an exception applies
annuity withdrawal:
A withdrawal is any amount distributed from the annuity that is not part of the annuitization process
IRA transfer
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
what's a big advantage of Savings Incentive Match Plan for Employees (S.I.M.P.L.E.) plans?
An advantage of a SIMPLE plan is the elimination of high administrative costs
Taxation of Annuities: 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.
Executive Bonus Plans
An executive bonus plan is one in which an employer pays the premiums on a permanent life insurance policy owned by an employee
what counts as a qualified distribution from a Roth IRA?
As long as the account has been open for at least 5 years and the owner is at least 59½, proceeds under a qualified distribution are received tax free
why are IRAs not considered "qualified" accounts?
Because IRAs are established by individuals
when must individuals start withdrawing from a qualified retirement plan in order to avoid getting a late withdrawal penalty?
Because most qualified plans defer taxes, individuals must start receiving distributions by April 1st of the year after they reach age 72 to avoid paying a penalty
why must individuals start withdrawing from a qualified retirement plan in order to avoid getting a late withdrawal penalty?
Because most qualified plans defer taxes, individuals must start receiving distributions by April 1st of the year after they reach age 72 to avoid paying a penalty
when aren't contributions to a traditional IRA taxable?
Contributions may be tax deductible unless the owner is a participant in an employer-sponsored retirement plan and gross income exceeds certain thresholds
why type of tax consideration are Executive Bonus Plans given?
Executive Bonus Plans are considered to be nonqualified plans
what is the normal fund distribution method?
FIFO (first in, first out)
What does failure to take all or part of an annual RMD result in?
Failure to take all or part of an annual RMD results in a 50% penalty tax on the amount not distributed.
For variable annuity income payments, what is done to determine the amount of each payment that is tax free?
For 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 annuitant's ordinary income tax rates.
MEC tax penalties:
Funds are subject to a 10% penalty on gains withdrawn prior to age 59 ½; LIFO distribution method makes it so that the entire policy needs to be lapsed in order to fully recover the basis
how may a Savings Incentive Match Plan for Employees (S.I.M.P.L.E.) plan be established as?
IRA or 401(k) plan
what is the contribution limit for those who own both a traditional IRA and a Roth IRA?
If a person owns a traditional IRA and a Roth IRA, the combined contributions to both cannot exceed the annual maximum IRA contribution for one IRA
What happens if a policyowner pays premiums in excess of the policy's guidelines
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
If employees elect a defined contribution plan: vs. If the plan is incorporated as a profit-sharing plan:
If employees elect a defined contribution plan: - Employees define their contribution amount as a percentage of income or a fixed dollar amount per payroll period. - The employer must deduct that amount from pay and forward to the plan custodian on a timely basis. - Participants typically invest in a portfolio of mutual funds. - Employers may contribute and match funds to participant accounts as long as the contribution formula is not discriminatory. If the plan is incorporated as a profit-sharing plan: - The employer defines the circumstances under which profit-based contributions will be made, and contributions must generally be made in at least 3 out of 5 consecutive years
how long does an IRA owner have to deposit the rollover check into a new IRA to avoid taxes and penalties?
If the payment from the initial account is made directly to the IRA owner, they will have 60 days to deposit the check into a new IRA to avoid taxes and penalties
what does IRA stand for?
Individual Retirement Account
When must individuals must start receiving distributions from a traditional IRA to avoid paying a penalty?
Individuals must start receiving distributions by April 1st of the year after they reach age 72 to avoid paying a penalty.
Who can contribute to a traditional IRA?
Individuals or married couples with earned income, up to the age of 70 1/2
what does Internal Revenue Code Section 1035 allow?
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
What does the 7-pay test do?
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.
who are Self-Employed Plans (HR-10 or KEOGH Plans) available to?
KEOGH Plans, or HR-10 Plans, are available to unincorporated sole proprietors and their eligible employees
what is the fund distribution method for a Modified Endowment Contact (MEC)?
LIFO (last-in, first-out) - That 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
what are non-qualified annuities funded with?
Non-qualified annuities are generally funded with after-tax dollars
why are contributions to a nonqualified plan not tax deductible?
Nonqualified plans do not meet requirements of federal law to be eligible for favorable tax treatment.
When do premiums paid by the employer in connection with group life insurance constitute taxable income to the employee?
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 $50,000. - All employer-paid premiums for amounts above $50,000 are reported as taxable income to the employee
roth IRA:
Roth IRA is a nondeductible tax-free retirement plan for anyone with earned income. Maximum annual contribution limits apply as set forth by the IRS, plus a catch-up contribution for persons age 50 or older.
Which qualified plan has replaced the Self-Employed Plans (HR-10 or KEOGH Plans)?
Simplified Employee Pensions (SEPs)
Who are Simplified Employee Pensions (SEPs) set up by?
Simplified Employee Pensions (SEPs) are set up by any private sector company that does not offer another type of qualified plan
What are Tax-Sheltered Annuities (TSAs)?
Tax-Sheltered Annuities (TSA) are qualified annuity plans benefitting employees of public schools under the Internal Revenue Code (IRC) Section 403(b), as well as other nonprofit organizations qualified under Section 501(c)(3) - These accounts are owned by the employee, are nonforfeitable, and will be paid upon death, retirement, or termination of the employee. - Contributions are pretax and the interest earned grows tax deferred.
which type of distributions are taxed in a modified endowment contract?
Taxable distributions include partial withdrawals, cash value surrenders, and policy loans (including automatic premium loans)
7-pay test:
The 7-pay test is a limitation on the total amount that can be paid into a policy in the first 7 years. - When a contract does not pass the 7-pay test, it is deemed a MEC
who makes contributions to a Simplified Employee Pensions (SEPs)?
The employer makes contributions and deducts the payments as a business expense. All distributions to employees are taxable upon receipt
tax effects on employer contributions to an executive bonus plan:
The employer may be able to deduct salary and compensation under Section 162 of the Internal Revenue Code (IRC)
Who can make contributions to a defined contribution plan?
The employer, employee, or both can make contributions
Why could flexible premium policies such as Universal and Variable universal life be classified as MECs?
The flexible premium feature allows the owner to pay premiums on their own schedule
When are life insurance policy loans taxed?
The loan is not taxed as long as the policy is in force, even if the loan amount is larger than the current basis. If the policy lapses with a loan outstanding, the excess over cost basis becomes taxable as ordinary income.
when is the payment of an accelerated death benefit tax-free?
The payment of an accelerated death benefit is tax free to a recipient if the benefit payment is qualified
when is the 10% tax penalty for withdrawaing before age 59 1//2 on a qualified retirement plan waived ?
The penalty may be waived for death, disability, qualified education costs, medical expenses, first-time home buyers, and substantial equal payments over life expectancy.
what establishes the the cost basis for a non-qualified annuity?
The premium paid for the non-qualified annuity, along with any subsequent premiums, establishes the cost basis for the non-qualified annuity
why was the life insurance transfer-for-value rule passed?
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
why are executive bonus plans classified as nonqualified plans?
These plans are nonqualified because they are designed to discriminate in favor of highly-compensated key employees
what does it mean for an employer's contribution to a SIMPLE plan to must be vested at 100%?
This means that the employee is entitled to all the employers' contributions immediately
how often are IRA owners allowed to do rollovers?
This type of transaction is reported to the IRS and is only allowed once in a 12-month period
when is a life insurance contract classified as a Modified Endowment Contract?
Under current law, if a policy is funded too quickly, it is classified as a Modified Endowment Contract or an MEC. - MEC rules impose stiff penalties to eliminate the use of life insurance as a short term savings vehicle
What happens when a contract does not pass the 7-pay test?
When a contract does not pass the 7-pay test, it is deemed a MEC
what are dividends paid out from?
a company's surplus earnings
why is a single premium policy deemed a modified endowment contract automatically?
because it clearly doesn't pass the 7-pay test
why are tax-qualified annuities still fully taxable at ordinary income rates when money is withdrawn?
because the premiums paid and subsequent premiums do not establish a cost basis
why are participating insurance companies' dividends not taxed?
because they're considered a return of the premium even though they're paid out as a result of surplus earnings
why aren't policy premiums tax deductible for personal policies?
because they're considered personal expenses
what does a catch-up contribution clause allow?
catch-up contributions towards their Roth IRA for persons age 50 or older
what does the cost recovery rule let a policyowner do?
discount their cost basis to determine taxable income from selling, surrendering, or withdrawing funds from a policy
which type of plan do Simplified Employee Pensions (SEPs) use?
employer-funded IRAs
In general, what is the way in which taxation of annuities is computed?
exclusion ratio
t/f: having an IRA prevents you from getting a work retirement plan
false
t/f: life insurance premiums can be overfunded and have its overfunded basis be undone in future years
false
when can taxpayers take a tax-free and penalty-free distribution of earnings from their Roth IRA?
in cases of a death, disability, or qualified first-time home purchase
for which type of rollover method is a 20% withholding of funds required for?
indirect rollover
which type of financial instrument is not a permissible investment for an IRA?
life insurance
what standards must retirement plans meet to be classified as "qualified plans":
must meet the requirements of ERISA (Employee Retirement Income Security Act), 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.
how many times is a person limited to do IRA transfers?
no limit; these can take place as often as desired
who are Savings Incentive Match Plan for Employees (S.I.M.P.L.E.) plans available for?
only available to companies with less than 100 employees and must be the only type of plan the company has available for the employees
defined benefit plan
pension plan that guarantees a specified level of retirement income
what is it that establishes a cost basis in a life policy?
policy premiums
what contributes to the growth of a cash value in a cash value policy?
premium and the interest and gains grown on the premium investment
what are tax-qualified annuities funded with?
pretax dollars
defined contribution plan
retirement plan in which the employer sets up an individual account for each employee and specifies the size of the investment into that account
who are Simplified Employee Pensions (SEPs) very popular with?
self-employed individuals
What does the IRS use to determine which part of the income benefit payment is a tax-free return of premium and which part is taxable?
tables and formulas
how is the benefit amount in a defined benefit plan determined?
the amount depends upon length of service and highest salary attained
what is the starting point for establishing gain or loss?
the basis
tax effect on employee contributions to a qualified plan:
the contributions to a qualified plan are either tax deductible or are pretaxed contributions
who can contribute to an executive bonus plan?
the employer and the employee whose plan it is
tax effects on an IRA transfer:
there are none
tax deductibility difference between a traditional IRA and a Roth IRA:
traditional: deductible Roth: nondeductible
t/f: once a policy is classified as a MEC, it maintains that classification for the life of the policy
true
t/f: the IRS prevents account rollovers from one IRA to the next
true
t/f: the interest paid on a permanent life insurance policy loan is not tax-deductible
true
t/f: Section 1035 allows for an exchange-only market for life insurance
true, however, Policyowners must be aware that surrender charges might still apply on the existing contract, and a new surrender charge period may start after the exchange on the newly acquired policy. Further, the new insurance contract may have higher fees and charges than the old one, which will reduce the returns or increase costs for such things as policy loans