Insurance Exam CH 7 Taxation and Personal Life Insurance
There are ____ broad categories of qualified retirement plans.
2 *defined benefit defined contribution
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.
A SIMPLE plan may be established either as a(n):
IRA or a 401(k) plan
MEC 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 Funds are subject to a 10% penalty on gains withdrawn prior to age 59 ½.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 ½ and distributions paid out due to death or disability are not subject to the penalty.
Which of the following scenarios will trigger an income tax due?
Interest earned on dividends left on deposit with the insurer *While the dividend is free from income tax the interest earned on the dividend is subject to tax.
H owns a nonqualified variable annuity that has a separate account invested in the stock market. If H withdraws funds from the annuity, the earnings on the withdrawal will be taxed as:
Ordinary Income *Regardless of the source of the gains inside an annuity, all taxable withdrawals are subject to ordinary income tax rates.
A life insurance 1035 exchange can only be completed after:
Proof of insurability has been provided and accepted *A life insurance 1035 exchange requires that the insured prove insurability in order to obtain new life insurance as part of the transaction.
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.
Employer-paid premiums for employee group term life do not constitute taxable income to the employee for coverage up to ___________.
$50,000
E has a $10,000 traditional whole life policy with a $4,000 cash value. Premiums paid to date are $3,500. If the policy lapses with a $4,000 loan outstanding, what amount will be taxable as income to E?
$500 *If a policy lapses with an outstanding loan greater than the premium paid in, tax must be paid on the difference. In E's case, that's $500 ($4,000 - $3,500).
There are two broad categories of qualified retirement plans:
-Defined Benefit Plan -Defined Contribution Plan
P is 75. P's required minimum distribution for this year is $10,000. P only withdraws $2,000. What is the consequence to P for this?
A $4,000 tax penalty *Failure to take all or part of an annual RMD incurs a 50% penalty tax on the amount not distributed. $10,000 - $2,000 = $8,000 x 50% = $4,000.
A Tax Sheltered Annuity may be established and funded by which of the following?
A not-for-profit community hospital association *403(b) plans are established for nonprofit organizations.
Which of the following establishes a cost basis in an annuity?
After-tax contributions *Cost basis is established with any after-tax premiums deposited into the annuity.
Which of the following IRA transactions is subject to taxation?
An IRA rollover reinvested 75 days after receipt *An IRA Rollover places a 60 day limit on reinvesting into another IRA without tax consequences.
All of the following tax-free exchanges of life insurance and annuities are permitted, EXCEPT:
Annuity to life insurance
If a non-qualified variable annuity owned for 15 years is surrendered, what is the income tax consequence?
Any amount received in excess of its cost basis is taxable as ordinary income *The same tax rules apply to both fixed and variable annuities. The funds received in excess of the cost basis are taxable as ordinary income.
Traditional IRAs
Anyone under the age of 70½ who has earned income may open an IRA. Contributions may be tax deductible in whole or part (or nondeductible if the owner is a participant in an employer-sponsored retirement plan and gross income exceeds certain thresholds). A nonworking spouse can also set up a Spousal IRA based on the working spouse's income. Contributions grow tax-deferred until they are withdrawn. There is a maximum annual contribution allowed by the IRS, as well as a "catch up" contribution for persons age 50 and older. All amounts contributed pre-tax plus gains withdrawn from an IRA are fully taxable as ordinary income.
How are employer paid premiums on a group life insurance plan treated for tax purposes?
As an ordinary and necessary business expense
When may an employer deduct the premiums it pays for an employee's life insurance benefit?
As long as the business does not derive a direct benefit from the policy *As long as the insurance death benefit is not payable to the employer when an employee dies, the premiums paid for the life insurance are deductible to the business.
Individual Retirement Accounts (IRAs)
Because IRA's 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.
Which of the following plans provides employees with a fixed and known benefit at retirement, the amount of which generally depends upon length of service and highest attained salary?
Defined benefit *A defined benefit plan provides employees with a fixed and known benefit at retirement, the amount of which generally depends upon length of service and highest attained salary.
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.
Cash Value- Sum of Premiums =
Equity
Premiums- Personal Life Insurance
For individuals, premiums are considered a personal expense and are not deductible. They are paid with after-tax dollars. This establishes a cost basis in the policy for tax purposes.
When would a life insurance policy loan be subject to income taxation?
If the policy lapses when there is a policy loan outstanding which is in excess of the policy's cost basis *Only the portion of an outstanding policy loan in excess of the policy's cost basis will be subject to income taxation if the policy lapses.
Single Premium Life insurance is always a
MEC or Modified Endowment Contract
Under ERISA qualified plans must meet all of the following requirements, except:
May discriminate in favor of highly compensated employees
ERISA sets ________ standards for pension plans in private industry.
Minimum *Sets minimum standards
F has a $100,000 face amount term life policy for which F paid $10,000 in premium to date. F dies and the benefit is paid out to G, the beneficiary. What amount of the death benefit received is taxable as income to G?
Nothing *Lump sum death proceeds are not taxable as income to a named beneficiary.
In order for the life insurance policy's death benefit to remain income tax free to the beneficiary, the transfer of policy ownership must ____________.
Qualify for one of the exceptions *In order for the life insurance policy's death benefit to remain income tax free to the beneficiary, the transfer of policy ownership must qualify for one of the exceptions.
Which of the following plans is for employees of non-profits and schools?
TSA's *403(b) Tax-Sheltered Annuities (TSA) are qualified annuity plans benefitting employees of not for profit organizations. This includes public, private, and parochial school employees as well as other nonprofit organizations as qualified by the internal revenue code 501(c)(3).
Generally, the payment of an accelerated death benefit is _______ to a recipient if the benefit payment is qualified.
Tax Free
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
What is "defined" in a defined contribution plan?
The percentage or amount of an employee's deposits to the plan *In a defined contribution plan, the employee chooses how much of his/her pay to contribute to the plan each payroll period. The employer deducts that amount from the employee's pay before income tax is calculated and remits that amount to the plan's custodian for the benefit of the employee.
All of the following are true regarding IRA transfers, except:
They can only take place once a year *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.
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.
All of the following will determine whether or not an IRA contribution is deductible, except:
Whether the IRA owner is over a specified age *An individual's age does not determine whether or not a contribution is deductible. Age may determine whether a contribution can be made, but not if it is deductible. All other choices determine if the contribution is deductible or nondeductible.
SIMPLE plans are only available to companies that have ______ employees or less, and must be the only type of plan the company has available for the employees.
100 *And must be the only type of plan the company has available for the employees. An advantage of a SIMPLE plan is the elimination of high administrative costs.
To be considered terminally ill, federal law defines a terminal illness as one which is expected to result in the person's death within how many months?
24 *Federal law establishes 24 months as a person's maximum life expectancy to be defined as terminally ill. For the activation of an accelerated death benefit rider, and for the purpose of limiting such claims, insurance companies often define terminal illness as one which would result in death within 12 months.
A public school teacher may contribute part of his or her paycheck income into a ____ plan and defer income taxes on not only the contribution but also the growth in the plan.
403(b)
If a life insurance policy does not pass the ___ -pay test, it will be deemed a MEC.
7 *7 pay test
Dividends
A participating insurance company's dividend consists of the amount of premium that is returned to the policyowner if the insurance company achieves lower mortality and expense costs than expected. Dividends are paid out of the insurer's surplus earnings for that year. The dividends themselves are not taxable since dividends are considered a return of unearned premium. When dividends: -Are left on deposit with the insurance company, interest earned on dividends is taxable as ordinary income in the year earned -Received exceed the total premium paid for the life insurance policy, the excess dividends are then considered taxable income
If the annuitant dies during the annuity or payout phase, the remaining value in the account will be:
Added to the deceased annuitant's estate for valuation *If the annuitant dies during the annuity or payout phase, the remaining value in the account will be added to the deceased annuitant's estate for valuation.
All of the following are characteristics of a 401(k) plan, except:
Employers must match employee contributions *Employer matching contributions are up to the employer when the plan is first put into place.
Policy Loans
If a policyowner takes out a loan against the cash value of a life insurance policy, the amount of the loan is not taxable. This is true even if the loan is larger than the amount of the premiums paid in. The loan is not taxed as long as the policy is in force. If the policy lapses with a loan outstanding, the excess over cost basis becomes taxable as ordinary income. The interest paid on a permanent life insurance policy loan is not tax-deductible.
Qualified plan employer contributions are tax deductible when _________.
They are made *Employer contributions are immediately tax deductible.
Example of Life Insurance Transfer for Value Rule
A $500,000 policy is transferred to a new owner and sold for $50,000. After the sale, the new owner pays $10,000 in life insurance premiums while the insured is alive. Upon death of the insured $60,000 ($50,000 + $10,000) of the death benefit is received income tax free to the beneficiary while $440,000 is taxable ($500,000 - $60,000).
Profit-Sharing and 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. 401(k) Plans 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.
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).
Defined Benefit Plan
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 attained salary. The company assumes the responsibility for making sure money will be available to fund a pension for retiring workers.
Defined Contribution Plan
A defined contribution plan provides employees with a retirement benefit based on the value of the employee's account at retirement. The employer and employee or both can make contributions. This is a type of retirement plan in which a certain amount or percentage of money is set aside each year by a company for the benefit of the employee.
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.
A qualified pension plan must meet ___________ requirements.
ERISA *A qualified plan must meet the requirements of the Employee Retirement Income Security Act (ERISA).
The federal law that governs the rights of plan participants and beneficiaries of most employer-sponsored benefit plans is ____________.
ERISA *The Employee Retirement Income Security Act defines the manner in which most employee benefit plans must be administered. Plans operated by federal, state, and local government agencies are generally exempt from the provisions of ERISA.
All of the following statements about Group Life Insurance are true, except:
Employees receive a tax deduction for employer paid premiums *Employer, not employee, paid premiums are tax deductible. Only when the insurance benefit exceeds $50,000 does the employee have to report it as taxable income.
MEC Taxation
If a contract is deemed to be a MEC, then any funds that are distributed are subject to a "last-in, first-out" (LIFO) tax treatment, rather than the normal "first-in, first-out" tax treatment. Taxable distributions include partial withdrawals, cash value surrenders and policy loans (including automatic premium loans).
All of the following statements regarding a Modified Endowment Contract are correct, EXCEPT:
If a policy is deemed a MEC, the owner has 7 years to receive a refund of excess premiums and remove the MEC status
An employer's contribution to a SIMPLE plan is vested _________.
Immediately at 100%
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.
Cash values within an ordinary straight whole life insurance policy _______ over time.
Increase *Cash values increase over time as premium is paid in and interest is reflected in the cash values shown in the policy's nonforfeiture table.
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.
Which of these is a qualified plan designed specifically for unincorporated self-employed individuals?
Keogh Plan *The key element in the description is a plan specifically designed for self-employed individuals.
All of the following are unique features of a Roth IRA compared to a traditional IRA, except:
Life insurance is an approved funding vehicle *Life insurance is not an acceptable method of holding IRA or Roth IRA assets. Qualified Annuities may be used instead.
Savings Incentive Match Plan for Employees (SIMPLE)
May be established either as an IRA or a 401(k) plan. The employer's contribution must be immediately vested at 100%. This means that the employee is entitled to all the employers' contributions immediately. SIMPLE plans are only available to companies that have fewer than 100 employees and must be the only type of plan the company has available for the employees. An advantage of a SIMPLE plan is the elimination of high administrative costs.
How often may a person perform a rollover from one IRA to another?
Once every 12 months
When the annuitant dies during the accumulation phase of the annuity, the beneficiary receiving the death benefit must pay income tax on any gain from the policy at _________ tax rates.
Ordinary Income
When the annuitant dies during the accumulation phase of the annuity, the beneficiary receiving the death benefit:
Pays income tax on any gains at his or her own income tax rate
All of the following are defined contribution plans, except:
Pension *There are several defined contribution retirement plans available including a 401(k) Plan, a 403(b) Plan, and a Profit-Sharing Plan. Variations of an IRA-based defined contribution plan include the Simplified Employee Pension Plan (SEP) and the Savings Incentive Match Plan for Employees (SIMPLE).
Janelle is the beneficiary of a life insurance policy in which the insured has died. What is the only way she can receive the claim amount totally free from income taxes?
Receive the claim amount in a lump sum *Any settlement option will generate taxable income to the beneficiary. The only way to be exempt from any income taxation is to receive the death benefit in a lump sum.
Simplified Employee Pensions (SEPs)
Simplified Employee Pensions (SEPs) are set up by any private sector company that does not offer another type of qualified plan. This plan is very popular with self - employed individuals. The SEP plan uses employer funded IRA's. The employer makes contributions and deducts the payments as a business expense. All distributions to employees are taxable upon receipt.
Rollovers and Transfers of IRAs
The IRS permits an IRA rollover from one account to another or a transfer. This may avoid taxation as an early withdrawal.
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.
Life Insurance Transfer for Value Rule
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. 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.
Why are dividends not taxable as income when paid out to a participating policyholder?
They represent a return of a portion of the premium paid *A participating insurance company's dividend consists of the amount of premium that is returned to the policyowner if the insurance company achieves lower mortality and expense costs than expected.
IRA Distributions
Withdrawals, known as Required Minimum Distributions (RMDs), from the account must start by April 1 of the year following the year the owner turns age 70½. Failure to take all or part of an annual RMD incurs a 50% penalty tax on the amount not distributed.
If funds are prematurely withdrawn from a Modified Endowment Contract (MEC) they are subject to a _____% penalty on any gains.
10 *For withdrawals of any gains from a MEC prior to age 59 1/2 there is a 10% tax penalty that applies.
Death Benefit Proceeds- Group Life Insurance
Death benefit proceeds from a group life insurance plan to an employee's named beneficiary are received income tax free.
Which of the following is a qualified retirement plan that bases an employee's retirement benefit upon length of service and highest attained salary?
Defined Benefit *A defined benefit plan usually bases the employee's retirement check on length of service and highest attained salary.
If a policyowner unintentionally pays premiums in excess of the MEC guidelines, the excess premium can be refunded by the insurer within 60 days after the ________.
End of the contract year
IRA Rollover
If the payment is made directly to the IRA owner, he/she will have 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 per year. A 20% withholding of funds is required unless a direct rollover occurs. 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 therefore no 60-day requirement.
Under what circumstance would a policy loan in a life insurance policy be taxable?
If the policy lapses or is surrendered, any loan amount in excess of cost basis is taxable
All of the following are transactions that qualify as a 1035 exchange, except:
A fixed annuity into an adjustable life insurance policy *Annuities cannot be 1035 exchanged into a life insurance policy.
Roth IRA
A nondeductible tax-free retirement plan for anyone with earned income. Maximum annual contribution limits apply as set by the IRS, plus a catch up contribution for persons age 50 or older. Unlike a 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 59½, proceeds under a qualified distribution are received tax free. Taxpayers can also take a tax-free and penalty-free distribution of earnings in cases of a death, disability or qualified first-time home purchase. A non-qualified distribution is subject to taxation of earnings and a 10% additional tax unless an exception applies. 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.
If an annuity is annuitized, then the _________ investment is recovered income tax-free over the income benefit payment period.
After-tax *Only the after-tax investment is recovered income tax-free from an annuity that is annuitized. It represents a return of the cost basis.
A Roth IRA is unique for which of the following reasons?
Contributions are nondeductible and distributions are nontaxable *Roth retirement plans are funded with after-tax (nondeductible) money. Under current tax law, distributions are received tax-free, including all gains.
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. If the annuitant dies during the annuity payout phase, the remaining value in the account will be 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.
If a taxable event occurs regarding the cash value of a permanent life insurance policy, in virtually every case, the taxable amount is taxed as:
Ordinary Income *In just about every case, if there is a taxable event associated with a permanent life insurance policy. The IRS considers it ordinary income.
Premiums Paid by the Employer and the Employee -Group Life Insurance
Group Term Life premiums paid by an employer are tax deductible to the business as an ordinary and necessary business expense. Any employee paid premiums are not eligible for a tax deduction. Employer paid premiums 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.
Tax-Sheltered Annuities (TSAs)
Qualified annuity plans benefiting 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). Employees of nonprofit organizations may have an arrangement with the employer whereby the employer agrees with each participating employee to reduce the employee's 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 and are nonforfeitable and will be paid upon death, retirement, or termination of the employee. Contributions are pre-tax and interest earned grows tax deferred.
IRA Premature Distributions
Withdrawals before age 59½ are generally subject to a 10% penalty tax. Once funded, permissible investments in an IRAs may be include mutual funds, common stock, certificates of deposit, or annuities, to name a few. For state exam purposes, life insurance is not a permissible investment in an IRA. 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