CFP - Insurance - Ch. 7: Income Taxation of Life Insurance

Fran Fine exchanges a $250,000 ordinary life insurance policy for an annuity contract. Fran paid $40,000 of premium over the life of the contract. The cash value of the contract is $38,000. What is the basis of the annuity contract?

$40,000

Janet, age 65, bought a whole life policy years ago. She has decided to surrender the policy. These are the facts: Guaranteed cash value = $75,000 Dividends used to reduce premium = $10,000 Existing loan = $30,000 Premiums billed = $60,000 What amount of cash would Janet receive at the time of surrender? What amount of the distribution would be taxable?

$45,000 = cash value of $75,000 minus the loan of $30,000 $25,000 = The taxable amount is the guaranteed cash value less the net premiums that were actually paid

Shelly, age 60, owns a $100,000 limited pay whole life insurance policy with a yearly premium of $5,000. After 10 years, she surrendered the policy. The current values are the following: Net cash value = $15,000 Outstanding loan = $30,000 Dividends used to reduce premiums = $10,000 What will her tax situation be?

$5,000 of ordinary income Actual cash value = $15,000 + $30,000 = $45,000 minus the basis of $40,000 = $5,000

How are distributions and loans under an MEC taxed?

-Taxed under the "interest first" rule -If a taxable distribution, which is not part of an annuitized distribution, is received under the contract before age 59.5 and the policyowner is NOT disabled, it's subject to a 10% federal penalty tax -Death benefit is excludable from income -Dividends paid by mutual life insurance companies under MECs are taxable as income if they are used as follows: ---If they're received in cash or to reduce premiums due ---If they're retained by the insurer in repayment of a policy loan

A contract is defined as an MEC if it meets the requirements for classification as a life insurance contract (the 1984 Act) and has both of the following characteristics:

1. Entered into on or after June 21, 1988 2. Fails to meet the "seven pay test"

The IRC defines a life insurance contract for income tax purposes. The policy must meet either of the following tests to qualify:

1. The cash value accumulation test, or 2. The guideline premium and corridor test

What are policy transfers that are NOT jeopardized by the transfer for value rule?

1. Transfer to the insured 2. Transfer to a partner of the insured (partnerships) 3. Transfer to a corporation in which the insured is a shareholder or an officer 4. Transfer pursuant to a divorce agreement

What is the taxable amount?

= the cash value LESS the basis Toby's basis = premiums paid LESS dividends received = $20,000 So, the taxable amount is $30,000 ($50,000 of cash value minus his basis of $20,000). The $30,000 is taxed as ordinary income (NOT capital gains)

Ted's parents bought him a $50,000 life insurance policy when he was 2. Now at age 25, he is the owner of the policy. It has $10,000 of cash value. Ted is planning to get married shortly. He wants to know which of the following options are available. Select all that apply. A. He can cash it in for $10,000 (may be partially taxable) B. He can exchange the policy for a larger face value (tax-free exchange) with proof of insurability C. He can roll the cash value in an annuity (tax-free exchange) D. He can exchange the cash value for a single life immediate annuity (tax-free payout) E. He can select the extended term nonforfeiture option

A, B, C, and E. Answers B and C are permissable 1035 exchanges. Answers A and E are nonforfeiture options.

What is a "material change?"

Any increase in the death benefit under the contract

The Uniform Simultaneous Death Act (USDA)

Any persons who dies within 120 hours of each other, by law, predecease each other

What amount is taxed at ordinary income rates?

Cash value above cost basis at the time of surrender

What did the 1988 Act do?

Eliminated most sales of single premium life insurance contracts (the 1984 Act)

Describe the taxation of dividends paid

Generally treated as return of unused premium and are not income taxable EXCEPT dividends from MECs

What is the impact of the USDA?

Keeps the property of one deceased person from passing through the estate of another deceased person before passing to those who survive both

7-pay test

Policies that fail the 7-pay test because excess premium has been paid within the first 7 years are classified as MECs A SINGLE PREMIUM POLICY ISSUED AFTER 1988 IS ALWAYS A MEC ON THE CFP EXAM

What are Rule #1 and Rule #2 regarding grandfathered life insurance rules? Who do they apply to?

Rule #1: If the death benefit increases BY MORE THAN $150,000, the contract becomes subject to material change rules and may lose its grandfathered status. Rule #2: If the policy death benefit is increased or an additional qualified benefit is purchased and the contract owner did not have the right to obtain such an increase or addition without providing additional evidence of insurability, it may lose its grandfathered status. They apply to both a) contracts issued prior to June 1988 and b) death benefit increases after 1988

Section 1035 Exchange

The IRC provides the following tax-free exchanges of life insurance and annuity contracts: -The exchange of a life insurance policy for another life insurance policy -The exchange of an annuity contract for another annuity contract -The exchange of a life insurance policy for an annuity contract -Tax-free exchanges are now permitted from life insurance and annuity contracts to qualified long-term care policies

What happens if the contract does not pass either test?

The policy is classified as a Modified Endowment Contract (MEC) and thus is taxed like an annuity

Toby, age 65, bought a whole life policy years ago that he now wishes to surrender. The following facts apply: Cash value = $50,000 Premiums billed = $35,000 Existing loan = $30,000 Dividends reducing premium = $15,000 At the time of surrender, how much will the insurance company pay him?

They will pay him the current cash value LESS the loan = $50,000 - $30,000 = $20,000

Describe the taxation of death benefits

They're generally INCOME tax free to the beneficiary* *An exception may apply under the transfer-for-value rule

T or F: A gift of a policy to a family member causes a taxable gift but NOT a transfer for value because no consideration is received.

True!

T or F: A policy that at first passes the 7-day test when issued can later become a MEC if there is a "material change" in the policy

True!

T or F: A sale of a policy to a family member (other than the insured) is NOT a taxable gift but does cause a transfer for value.

True!

Martin purchased a single-premium policy in 1996. The policy fails the 7-pay test because all premiums were paid at once. Later, Martin exchanges his single premium policy for a larger level premium policy that clearly passes the 7-day test. Will the new policy be treated as an MEC or no?

Yes! Once an MEC, always an MEC!

Taxation of distributions under an MEC is similar to the taxation of a _____

deferred annuity

In an MEC, loans against the contract are also treated as ______

distributions

Transfer for Value Rule

if a policy is transferred from one owner to another for valuable consideration, the income tax exclusion is lost (ex: viatical settlement).

The difference between non-MEC and MEC contracts is that:

loans and withdrawals with non-MEC contracts are generally NOT taxable

Withdrawals and loans against a life insurance policy do not count as taxable income UNLESS

the policy is surrendered or lapses and the amount owed exceeds what was paid in

In order for the exchange to qualify as a tax-free exchange, if an exchange involves life insurance policies, the policies must have:

the same owner and insured If an annuity is exchanged, the contracts must name the same owner and the same annuitants

The most important exception to the general rule of exclusion of life insurance death proceeds from federal income taxation to the beneficiary is the:

transfer for value rule