Chapter 7: Federal Tax Considerations and Retirement Plans
surrendering a cash value
any gains are subject to federal and possibly state income tax. gain = gross cash value paid out + loans - cost basis while the insured is alive, the sum in excess of the cost basis is taxable as ordinary income.
Traditional IRAs
anyone with taxable income may contribute to 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
Distributions at death
- beneficiary is subject to taxation of earnings if owner dies during accumulation phase
estate taxes and benefits included
- federal estate taxes
Qualified Retirement plans
- must meet the requirements of ERISA (Employee Retirement Income Security Act), a federal law that sets minimum standards for pension plans in a private industry. ERISA 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
policy loans
- not taxable even when loan is greater than premiums paid as long as policy is in force
Accumulation Phase (nonqualified annuities)
Upon contract surrender or partial withdrawal, taxed on earned interest - penalty may apply
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.
Premature Distributions
Withdrawals before age 59½ generally are subject to a 10% penalty tax.
Roth IRA
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.
Qualified plans
- receive favorable tax treatment -Employer contributions are immediately tax deductible to the employer at the time the contribution is made. -These contributions are not taxable to the employee until withdrawn. -Employee contributions are either pretax or tax deductible. - Distributions taken prior to age 59 ½ are subject to taxation and a 10% penalty. The penalty may be waived for death, disability, qualified education costs, medical expenses, first-time home buyers, and substantial equal payments over life expectancy. - 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.
Individual annuities
- tax-qualified annuities are generally funded with pre-tax dollars - fully taxable at ordinary income rates when money is withdrawn because the premiums paid and subsequent premiums do not establish a cost basis
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
Exclusion Ratio
- the way in which taxation of annuities is computed - IRS has tables and formulas to determine which part of the income benefit payment is a tax-free return of premium and which part is taxable
Cost Basis
cost basis = the amount of premiums paid into the policy - any dividends or withdrawals previously taken. - Any withdrawals in excess of the cost basis are taxed as ordinary income.
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
Life Insurance Transfer-for-Value Rule
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 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.
7-pay test
- When a contract does not pass the 7-pay test, it is deemed a MEC. - it is a limitation on the total amount that can be paid into a policy in the first 7 years -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. - If a policy owner 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. - single premium life insurance policy clearly does not pass the 7-pay test, it is automatically deemed a MEC. -
Modified Endowment Contracts (MECs)
- classified as MEC if policy is funded too quickly - imposes stiff penalties to eliminate the use of life insurance as a short term savings vehicle
dividends
- dividends are not taxable - interests from the dividends are taxable as ordinary income - if dividends received exceed the total premium paid for the life insurance policy, excess dividends are considered taxable income
Nonqualified plans
- do not meet requirements of federal law to be eligible for favorable tax treatment. - Because of this, contributions to a nonqualified plan are not tax deductible. - In many cases, such as a nonqualified annuity, the earnings are still tax deferred until withdrawn. Upon withdrawal, only the earnings are taxable
Required Minimum Distributions (RMDs)
- failure to take all or part of an annual RMD results ina 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
Cash Values
- increases annually - not taxable at time interest is credited to the policy - upon surrender, owner is taxed on the equity equity = cash value - sum of premiums any earnings in the cash value are allowed to grow on a tax-deferred basis until - the policy is surrendered - the policy is transferred for value (sold ore assigned) - the policy ceases to meet the IRS definition of a life insurance contract
death benefit proceeds (claims)
- not taxable when lump sum - settlement option interests or earnings are taxable as ordinary income
Annuity Phase
- percentage of principal to interest determines the exclusion ratio
Traditional IRA
Contributions - anyone under age 70 1/2 with earned income can contribute to an IRA - contributions are deductible in most cases - earnings grow tax-deferred until withdrawn Distributions - payments from the account must start by age 70 1/2 or a 50% penalty on the amount that should have been withdrawn applies - premature distributions before 591/2 will incur a 10% penalty unless certain qualifying events occur, such as long term disability, qualified first time home buyer, or excessive medical expenses
Death Benefit proceeds
Death benefit proceeds from a group life insurance plan to an employee's named beneficiary are received income tax free.
Taxation of Group Life Insurance
Group term life premiums paid by an employer are tax-deductible to the business as an ordinary and necessary business expense - 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
Individual Retirement Accounts (IRAs)
IRAs are established by individuals, they are not considered "qualified plans" - IRAs are described in Section 408 of the Tax Code and have their own set of rules. - This means an individual can set up a traditional or Roth IRA, whether or not the employer has established a qualified plan at work.
Cost Recovery Rule
If the policyowner does sell, surrender, or withdraw funds from the policy, the difference between what is received and what had been paid in is taxed as ordinary income.
Qualified Plans Vs Nonqualified Plans
Qualified Plans - Must meet ERISA minimum standards - Contributions made by employee are tax-deductible or pre-tax - Entire amount of withdrawal is taxable to the employee upon distribution Nonqualified Plans -Employee contributions paid with after-tax dollars (non tax-deductible) - upon withdrawal, only the earnings are taxable - usually not funded by the employer until the employee actually retires
Penalties for MECs
all cash value transactions are SUBJECT TO TAXATION and penalty - premature distribution : 10% penalty on gains withdrawn prior to age 59 ½ excemptions - distributions made on or after 591/2 - distributions made due to death or total disability
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.
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 - during the annuity phase, the total remaining in an account is included in the deceased annuitant's estate
Premiums
individuals -premiums are not tax-deductible Employer - premiums tax-deductible as a business expense Group -employer-paid premiums are not taxable to the employee unless the benefit exceeds $50,000 -premiums paid for benefits over $50,000 are taxable
Types of exchanges the IRS will allow on a tax-free basis
no gain or loss is recognized - life insurance to life insurance - life insurance to annuity - annuity to an annuity - life insurance or annuity to long-term care - But NEVER an annuity to life insurance
Accelerated Death Benefits
tax free to a recipient if the benefit payment is qualified - 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
MECs tax
taxed on a "last-in, first-out" (LIFO) basis, rather than the normal "first-in, first-out" tax treatment. 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. Taxable distributions include partial withdrawals, cash value surrenders, and policy loans (including automatic premium loans).
Section 1035 Exchanges
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. - 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