Life and Health Ch 7 Fed Tax Considerations and Retirement Plans

Which of the following policies would be deemed a MEC?

Single Premium Whole Life *Since a single premium life insurance policy clearly does not pass the 7-pay test, it will automatically be deemed a MEC.

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.

Self-Employed Plans (HR-10 or KEOGH Plans)

Also known as an HR-10 plan Provided for the self-employed individual or partner Corporate officers are NOT eligible Annual contributions to a Keogh plan are tax-deductible Keogh plans may be funded by Life Insurance They have the same early-withdrawal penalties as IRAs

Cost Recovery Rule

Cash Value - Sum of Premiums = Equity

Death Benefit Proceeds

Death benefit proceeds from a group life insurance plan to an employee's named beneficiary are received income tax free.

Two categories of qualified retirement plans

Defined Benefit Plan Defined Contribution Plan

Nonqualified Plans

Nonqualified: 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

Which of the following would NOT be permitted as a Section 1035 policy exchange?

An annuity contract exchanged for a life contract

Accelerated Death Benefits/Qualifications

Generally, the payment of an accelerated death benefit is 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

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 (e.g. sold or assigned) The policy ceases to meet the IRS definition of a life insurance contract

Qualified plan employer contributions are tax deductible when _________.

They are made *Employer contributions are immediately tax deductible.

An annuitant contributed $50,000 to her nonqualified annuity, and when she annuitized the policy, the insurance company determined that, based on her life expectancy, she will receive $100,000 in payments. If her initial monthly payment was $1,000, how much of that payment was taxable?

$500 *Distributions from a nonqualified annuity are never tax-free. The initial monthly payment will never be fully taxable. $50,000 (cost basis) divided by $100,000 (expected distribution) equals 50% (0.50). $1,000 x 0.50 = $500.

Savings Incentive Match Plan for Employees (S.I.M.P.L.E.)

-may be established either as an IRA or a 401(k) plan. The employer's contribution must be immediately vested at 100%. -are only available to companies that have 100 employees or less 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.

If a life insurance policy does not pass the ___ -pay test, it will be deemed a MEC.

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Modified Endowment Contracts (MECs)

A life insurance policy that has too much money (premiums) paid into it in the first seven years (the 7 pay test) fails to meet the standard established

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.

If no __________ is living at the time of the insured's death, the benefit will automatically be paid into the insured's estate.

Beneficiary

Section 457 Deferred Compensation

Employees of states, counties, and municipalities may set up an arrangement where the employer agrees with each employee to reduce his/her pay by a specified amount and to invest the deferrals in one or more investments for the employee's retirement. These amounts will be distributed to the employee upon death, retirement, or termination. Deferred annuities are a popular investment for these types of plans.

Penalties (MECs)

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

Traditional IRAs

Individual retirement arrangements in which qualified contributions are tax deductible and income and capital gains on investments within the account are not taxed until the money is withdrawn after age 59 1/2

The cost basis of a life insurance policy is __________.

Premiums paid less dividends or withdrawals

ERISA sets minimum standards for pension plans primarily in the ______ industry.

Private

The early withdrawal tax penalty on an IRA account may be waived in all of the following circumstances, EXCEPT: A Purchase of a vacation home B Educational expenses C Disability D Medical expenses

Purchase of a vacation home *There is an exception of up to $10,000 for first-time home buyers. A vacation home would not qualify as a first home.

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.

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.

There are ____ broad categories of qualified retirement plans.

2 *There are two broad categories of qualified retirement plans: defined benefit and defined contribution.

A non-school employer can set up a TSA plan for their employees under which of the IRC section?

501(c)(3) *A non-school employer that is a non-profit organization can set up a TSA for its employees under IRC 501(c)(3).

Cash Values

A cash value policy will generally experience increases in the cash value annually. Part is from the premium and part is from any interest or gains. The interest or gains are not taxable at the time they are credited to the policy.

Section 1035 Exchanges

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. 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

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.

All of the following tax-free exchanges of life insurance and annuities are permitted, EXCEPT: A Life insurance to long term care insurance B Life insurance to an annuity C Annuity to long term care insurance D Annuity to life insurance

Annuity to life insurance

A Roth IRA is unique for which of the following reasons? A Contributions are tax deductible and distributions are taxable B Contributions are nondeductible and distributions are taxable C Contributions are nondeductible and distributions are nontaxable D Contributions are tax deductible and distributions are nontaxable

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.

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.

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 *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 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.

Rollover

The payment is made directly to the IRA owner. The owner 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. There is no 60 day requirement.

Simplified Employee Pensions (SEPs)

an arrangement whereby an employee establishes and maintains an individual retirement account(IRA) to which the employer contributes.

Policy Loans

loans made by an insurance company to its policyholders using their policies as collateral the amount of the loan is not taxable

Exclusion Ratio

method of determining which part of an annuity payment is taxable, and which part represents the tax-free return of the annuitant's after-tax cost basis.

Roth IRA

private retirement plan that taxes income before it is saved, but which does not tax interest on that income when funds are used upon retirement There are many owners' benefits with the following being the most distinct. -The contribution period may exceed age 70½ -The IRS code pertaining to the minimum distribution of IRA's does not apply -Qualifying annuitants receive distributions tax free

Estate Taxation

the death benefit of a life insurance policy may be included in the insureds taxable estate at death and can be subject to the federal estate tax However, if the annuitant was receiving income from a pure life or straight life annuity, the company keeps the balance and nothing goes into the annuitant's estate for valuation..

Defined Benefit Plan

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. The company assumes the responsibility for making sure money will be available to fund a pension for retiring workers.

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. **For state exam purposes, life insurance is not a permissible investment in an IRA.

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, and 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.

Tax-Sheltered Annuities (TSAs)

Employees of public educational institutions (such as public schools and universities), tax exempt non-profit organizations and church organizations may exclude from their gross income, within limits, premiums paid on a contract that will provide for an annuity upon retirement All distributions from TSAs are taxable as ordinary income and 10% IRS early withdrawal penalties may apply if a participant is under age 59 ½

Premiums Paid by the Employer and the Employee

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 does 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.

A SEP uses employer funded _______ accounts.

IRA *Section 501(c)(3) is the section of tax code that defines what a non-profit organization is. Section 403(b) is the section of tax code that specifies who may participate in a 403(b) retirement plan.

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.

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.

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. When dividends Are left on deposit with the insurance company, interest earned on the dividends is taxable as ordinary income in the year earned When dividends Received exceed the total premium paid for the life insurance policy. The excess dividends are then considered taxable income.

Taxation (MECs)

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). *A MEC is not a type of life insurance rather it is what it becomes classified as and the ordinary tax rules that apply to life insurance are different. *Know that MEC's are subject to unfavorable tax rules and consequences.

All of the following statements regarding a Modified Endowment Contract are correct, EXCEPT: A A policy that fails the 7-pay test will be deemed a MEC B Distributions on gains withdrawn from a MEC prior to age 59 1/2 are subject to a 10% penalty in addition to taxation C If a policy is deemed a MEC, the owner has 7 years to receive a refund of excess premiums and remove the MEC status D Distributions received from a MEC are subject to a LIFO tax treatment

If a policy is deemed a MEC, the owner has 7 years to receive a refund of excess premiums and remove the MEC status

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 *Policy loans and unpaid loan interest are subject to taxation if the loan amount exceeds the cost basis (premiums paid less any dividends received in cash) in the contract in the event the policy lapses or is surrendered for its cash value. Surrender charges, if any, may be applied as an offset to cost basis.

7-Pay Test

if premiums paid during the first 7 years exceed the net level premium that should have been paid, it is a MEC (Modified Endowment Contract)

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.

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.

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.

Qualified Plans

must meet the requirements of ERISA (Employee Retirement Income Security Act), which is a federal law that sets minimum standards for pension plans in private industry. Under 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

A Tax Sheltered Annuity may be established and funded by which of the following? A Johnson Accountants, Inc. B A professional law firm C XYZ's Catering, a small unincorporated business D A not-for-profit community hospital association

A not-for-profit community hospital association *403(b) plans are established for nonprofit organizations.

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.

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. Employee contributions to the plan are made on a pre-tax basis.

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 Example: 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).

All of the following are true regarding IRA transfers, except: A It is a transaction between the same types of plan, such as two IRA accounts B Funds are directly transferred from one financial institution to another C Transfers are not taxable events D They can only take place once a year

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.

J makes a contribution to her IRA. All of the following information determines whether J's contribution is tax-deductible, EXCEPT: A Whether J participates in an employer sponsored retirement plan B Whether J is over a specified age C Whether J's IRA is a Traditional or a Roth D Whether J has income over a certain amount

Whether J is over a specified age *Age may determine whether a contribution is allowed, but does not determine if it is deductible. All other choices determine if the contribution is deductible or nondeductible.

Premature Distributions

Withdrawals before age 59½ are generally are subject to a 10% penalty tax. An IRA account owner may take an early withdrawal from an individual retirement account 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