CH 7
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).
If a life insurance policy does not pass the ___ -pay test, it will be deemed a MEC.
7 When a life insurance policy does not pass the 7-pay test, it will be deemed a MEC.
_________ consist(s) of the amount of premium that is returned to the policyowner if the insurer achieves lower mortality and expense costs than expected.
A dividend A participating insurer's dividend consists of the amount of premium returned to the policyowner if the insurer achieves lower mortality and expenses than expected.
Life insurance policy premiums establish a _________ in the policy for tax purposes.
Cost basis Cost basis is primarily established by accounting for the premiums paid into the policy.
ERISA is a ________ law.
Federal
If life insurance proceeds are paid to the deceased's estate they may be subject to ________ taxes.
Federal Estate While the death benefit is income tax free, the amount in the deceased's estate may be subject to Federal Estate taxes.
When withdrawing cash from a cash value life insurance policy, the amount of the withdrawal up to the policy's cost basis is tax-free. This tax accounting rule is referred to as:
First-In, First-Out (FIFO) FIFO accounting is first-in, first-out, which is why the recovery of amounts up to the cost basis are income tax-free.
Which of the following best defines the 'Cost Recovery Rule'?
Generally, the difference between the amount of cash value received and the amount of premium paid in is subject to income tax upon surrender The 'Cost Recovery Rule' stipulates that upon a partial withdrawal of cash or the surrender of a policy, the cash value in excess of premiums paid (cost basis) is subject to income tax.
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
Death benefits paid from an employee group life insurance plan to an employee's named beneficiary are received __________.
Income tax-free
The Modified Endowment Contract (MEC) rules were put into place because:
Individuals were overfunding life insurance policies and using them as tax-free investment vehicles instead of a way to protect survivors against the financial cost of one's death
Any employee-paid group life insurance premiums are __________.
Not tax-deductible
Contributions to a nonqualified plan are:
Not tax-deductible
The cost basis of a life insurance policy is __________.
Premiums paid less dividends or withdrawals
Which is true regarding the taxation of the cash value in a Universal Life Policy prior to withdrawal?
Tax deferred All life insurance cash value accumulations are tax deferred. The primary benefit of Universal Life is the potential of a higher interest crediting rate than the fixed rate in whole life policies.
Death benefits are paid to the estate of the policyowner/insured in which of the following situations?
The beneficiary is the estate
If dividends are left on deposit with an insurer to earn interest:
The dividend is tax-free, but the interest is taxable
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.
All of the following are times in which life insurance policy cash values can become taxable, except:
When a policy loan is taken out
The life insurance policy cost basis consists of:
he premiums paid in The premiums paid establish a cost basis in the policy.
If, as the result of an injury or illness, the insured is deemed to be terminal (i.e., expected to die within 1 or 2 years), what rider added to a life insurance policy would advance a portion of the face value?
Accelerated Benefit (Living Need) The Accelerated Benefit or Living Need Rider advances a portion of the death benefit to the owner if the insured is diagnosed with a terminal condition (i.e., death expected within 2 years).
How are employer paid premiums on a group life insurance plan treated for tax purposes?
As an ordinary and necessary business expense Employer paid premiums on a group life insurance plan are treated as an ordinary and necessary business expense which is why it qualifies for tax deductibility.
If no __________ is living at the time of the insured's death, the benefit will automatically be paid into the insured's estate.
Beneficiary 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.
A qualified plan pre-mature withdrawal tax penalty can be waived in all of the following circumstances, except:
Buying a first vacation home First-time home buyers, meaning primary residence would be one of the exceptions but not for a vacation home.
All of the following are ways in which the 10% additional tax can be waived, except:
Buying a new car Distributions taken prior to 59 1/2 are subject to taxation and a 10% penalty. The penalty may be waived for death, disability, qualified education costs, medical expenses, first-time homebuyers, and substantially equal payments over life expectancy.
All of the following regarding employer group life insurance are true, except:
Employee-paid premiums are tax-deductible to the employee
All of the following are true regarding ERISA qualified plans, except:
Employers must establish a pension plan
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.
Which of the following statements about a Modified Endowment Contract (MEC) is FALSE?
If a contract is deemed a MEC, any funds distributed are subject to a first-in/first-out (FIFO) tax treatment Any funds distributed are subject to a last-in, first-out (LIFO) tax treatment, meaning gains will be taxed before principal.
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.
If no beneficiary is living at the time of the insured's death, the benefit will automatically be paid __________.
Into the insured's estate 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.
If a(n) ________ does not pass the 7-pay test, it will be deemed a Modified Endowment Contract (MEC).
Life insurance policy
Which of the following is NOT a taxable event for a Modified Endowment Contract (MEC)?
Lump sum death benefit paid to the beneficiary Withdrawal of any cash value to pay for a daughter's wedding, policy loans, and cash surrender of the policy are all taxable distributions. Lump-sum death benefits are considered to be tax-free life insurance proceeds.
ERISA sets ________ standards for pension plans in private industry.
Minimum
____________ plans do not meet the requirements of federal law to be eligible for favorable tax treatment. A ERISA
Non-qualified Non-qualified plans do not meet the requirements for favorable tax treatment; qualified plans do.
For an individually purchased life insurance policy, the premiums are considered a __________.
Nondeductible personal expense The premiums paid for an individual life insurance policy are a personal expense and are not deductible.
All of the following are TRUE regarding qualified plans, except:
Plans can discriminate in favor of highly compensated employees In an ERISA-qualified plan, there can be no discrimination in favor of highly compensated employees.
All of the following regarding policy loans are true, except:
Policy loans are taxable if the policy remains in effect and the amount borrowed exceeds the premiums paid
ERISA requires which of the following?
Qualified plans must meet certain minimum standards
A permanent policy is surrendered for its cash value, and that sum is greater than the amount of premiums paid in. How is the excess taxed?
Taxed as ordinary income Upon surrender, any equity (i.e., amount above total premiums paid) is taxed as ordinary income. The premiums paid are also referred to as 'cost basis.
To eliminate the use of life insurance as a short-term, tax-free savings vehicle, what tax law change took place?
The Modified Endowment Contract (MEC) rules were put into place The rule states that if a policy is funded too quickly, it will be classified as a Modified Endowment Contract (MEC). MEC rules impose stiff penalties to eliminate the use of life insurance as a short-term, tax-free savings vehicle.
To be a qualified accelerated death benefit it must meet all of the following criteria, except:
The benefit amount cannot exceed the lesser of $50,000 or 7.5% of AGI To be a qualified accelerated death benefit the benefit 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, and 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 portion of an employee's pension plan withdrawal is subject to tax?
The entire withdrawal Since the contributions were pre-tax and all earnings were tax deferred, then the entire withdrawal would be subject to taxation unless one of the exceptions apply.
Which of the following scenarios will cause the value of a life insurance policy death benefit to be included in the insured's estate?
The insured is also the policyowner If the policyowner and the insured are the same person, the death benefit will be included in the insured's estate.
Clayton is asking his life insurance producer about any potential taxation issues related to his $100,000 personal Whole Life policy. All of the following are TRUE, except:
The interest that he pays on policy loans is tax-deductible The interest on policy loans is not tax-deductible.
Once a policy is classified as a MEC, it will maintain that classification for ____________.
The life of the policy
H is employed by a company that provides group life insurance. How much of the employer-paid premiums for H's $150,000 coverage, if any, is going to be reported as taxable income to H?
The premium paid for $100,000 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.
Participating policy dividends become taxable as income when:
The total amount of dividends received by a policyowner exceeds the total amount of premium he/she has paid When the total amount of dividends received exceeds the total amount of premium paid, the excess is taxable as income to the policyowner.
Qualified plan employer contributions are tax deductible when _________.
They are made