Fed Tax Considerations
Section 1035 Exchanges (apply to using cash surrender to purchase a new policy)
-IRS has ruled the following exchanges are tax deferred: 1)the exchange of a life policy for another life policy/for an endowment/annuity contract 2)the exchange of an endowment for an annuity 3)the exchange of an annuity for another annuity 4)the exchange of a life policy, endowment/fixed annuity for a variable annuity -The exchange may be made with a different company -If the exchange involves life ins policies, the policies must be on the same insured -If the exchange involves an annuity, contracts must be payable to the same person
"7-pay" test: any ins. contract will fail to meet 7-pay test if the amt paid in premiums during the 1st seven yrs exceeds the amt of 7 level annual premiums required to pay up the policy
-Technical & Misc Revenue Act (TAMRA) established special rules for life insurances, including endowments, which fail to meet the "seven-pay"
-regular IRA can be rolled over to a Roth IRA without incurring 10% IRS early withdrawal penalty, but rolled over funds are taxable & must bed reported as ordinary income
-although Roth IRA owners don't have to begin taking distributions at age 70 1/2, the Required Minimum Distribution Rules do apply once the IRA owner dies
Modified Endowment Contracts (MECS)
-any endowment contract that fails 7-pay test. -distributions from Modified Endowments are subject to taxation rules that differ from taxation rules of endowments & life ins that don't fail 7-day test
Taxation of Personal Life (continued)
-any interest accrued & paid is taxable. For ex: if proceeds are left with insurer under "interest only" settlement option, interest payments would be taxable -dividends are not taxable since they're considered a return of "overpaid premiums" -cash surrenders may generate taxable income it amt withdrawn exceeds total amt of premiums paid in For ex: purchase a whole life for $100K at 30 with premium of $1,000/yr. At 65, cash value will be $40K, which is $5,000 more than premiums paid in. The difference is tax-deferred interest that cash value has earned over the years. If taking cash surrender of $40K at 65, will have to pay ordinary income tax on $5,000 interest. The $35K is not taxed, since it's a return of money paid in over the yrs which was already taxed since premiums paid was after tax
Traditional IRAs
-any1 with earned income who is under 70 1/2 is eligible to open an IRA. -IRAs help people to save $ for retirement by allowing them to deduct contributions to these accts from their pre- tax $ for income tax purposes -these tax-deferred compensation will only be taxed when withdrawn from the acct at retirement (when in lower tax bracket)
Roth IRA
-contributions are not tax deductible -interest earned & distributions are tax free if Roth IRA is maintained for @ least 5 yrs & distributions are used to buy a 1st home, for qualified higher education expenses or recipient has attained age 59 1/2, died or has become disabled
Taxation of Personal Life Insurance
-premiums paid on individual life insurance are viewed as "personal" expense & are not deductible -premiums paid by employer on noncontributory group life plans are viewed as a business expense, therefore they are deductible -premiums paid by employee on contributory group life plan are not deductible -proceeds are exempt from income tax, even though they may exceed the cost of insurance (premiums paid) -if no beneficiary named, proceeds paid out to estate may be subjected to estate taxes -policy loans are not considered income & are not taxable
Required Minimum Rules
-require that the beneficiary withdraw the entire IRA balance over their lifetime. -if the spouse is beneficiary, they can elect to be treated as IRA owner & distributions would not have to begin until they die
distributions, including loans, from a modified endowment are taxable as income at time received to the extent that cash value exceeds premium paid. This means distributions from MECs are taxed as income 1st & recovery of cost basis (premium paid in) 2nd (LIFO); 10% penalty tax is imposed unless taxpayer is disabled/past age 59 1/2
7-pay test is administered when contract is 1st issued & once classified as a "Modified Endowment Contract" for the life of the contract. Also, when making a "material change" (increase in death benefit) to life ins. policy may subject to the rules concerning MECs. All MECs issued by same insurer to same policyholder within any calendar year are treated as 1 MEC
since most annuities are nonqualified (purchased with after-tax $), the amt of money put in (tax "basis"/cost basis) will someday be returned tax-free. However, since the earnings in annuity are tax-deferred, it'll be taxed as ordinary income when taking out. You never incur capital gains on an annuity
For ex: you purchase a Single Premium Deferred Annuity (SPDA) with a lump sum of $20,000 (after tax) at age 30. During accumulation stage, interest is earned (tax-deferred). At age 60, balance is $100K & cash surrender is exercised. Of this distribution, $80K would be taxable at ordinary income-tax rates. If you are in 28% tax bracket, this distribution will cost you $22,400 in taxes. If taking out before 59 1/2, 10% IRS penalty on the interest on top of income tax
Although IRA acct values are included in ower's estate upon death, the minimum distribution requirements that apply after the owner's death depend on whether they died before/after their required beginning date.
If an IRA owner dies before their requires beginning date, distributions must be made under either life expectancy method/the five-yr rule
since Roth IRAs are purchased with after-tax $, owners may always withdraw contributions without tax/penalty. Penalties only apply to acct earnings
Traditional IRA purchased with before-tax $, entire amt of premature distribution would be subject to income tax & penalties
Individuals may roll over IRA into another IRA without tax liability if the proceeds are reinvested in the new IRA within 60 days following receipt of distribution. Any amt can roll over, but rollovers are only allowed once a year. Rollovers may be subject to withholding tax, unless it's a trustee-to-trustee direct roll over
Traditional IRAs are subject to Required Minimum Distribution (RMD) rules, which states that if participant does not begin withdrawals by age 70 1/2, a 50% penalty will be levied by IRS upon amt that should have been withdrawn, but wasn't
Traditional IRAs (continued)
a qualified person may contribute 100% of annual earn income if: (subject to specified max limits) 1)a wage earner & not xtively participate in an employer maintained retirement plan or 2)a wage earner who xtively participates, but has an adjusted gross income less than a certain amt
Life expectancy rule
if any portion of interest is payable to beneficiary, that portion must be distributed over the life expectancy of beneficiary, beginning with 1 yr of owner's death
Exclusion ratio
instead of cash surrender, you can annuitize to spread tax bill over a lifetime. For ex: at 60, you might expect to live another 20 yrs, so ins company will return $20k basis to you tax-free over 20 yr period. So, the first $1000 you receive each year is tax-free return of capital. Any amt above that each yr would be taxed as ordinary income. If you lived longer 20 yrs, all your payments would be 100% taxable, since you have recovered all your cost basis
-if annuitant dies during accumulation (pay-in) period, beneficiary will be paid as a death benefit the premiums paid or the accumulated cash value, whichever is more -if it's a corporation who owns deferred annuity, contract will not be treated for tax purposes like an annuity. Instead, income on the contract is treated as ordinary income received by the corporation during taxable year
payment of death benefit during accumulation period may be deferred when there is a beneficiary. Internal Revenue Code allows surviving spouse to "step into the shoes" of the deceased contract owner & continue accumulation period without change a new contract owner
five-year rule
the entire interest must be distributed within 5 yrs after owner's death, regardless of who receives the distribution
Waiver of IRA Premature Distribution Penalties (10%) (premature distributions may still be taxable)
the premature distribution penalty (before 59 1/2) does not apply to distributions: 1)made to a beneficiary/to the owner's estate, made after death of the owner 2)attributable to owner's disability 3)which are part of a series of substantially equal periodic payments (spread over a lifetime) 4)made for medical care, to the extent that the payment exceed 10% of adjustable gross income 5)made to an unemployed owner for payment of health ins premiums 6)made to pay qualified higher education expenses, & 7)made to 1st-time homebuyers ($10K lifetime limit), who is some1 who has not owned a house for @ least 2 yrs
an eligible IRA owner may also create a Spousal IRA with a non-wage-earning spouse. Must be 2 separate IRA accts
traditional IRA owner must begin to receive payments by the time they reach 70 1/2. Withdrawals before 59 1/2 subject to 10% penalty. In addition, amts withdrawn must also be added to owner's taxable income for the year in which it was received.
