Series 6: Variable Products (Variable Life Insurance Taxation)

Which statements are TRUE? I Distributions taken after age 59 1/2 from non-qualified variable annuity contracts are taxable to the recipient II Distributions taken after age 59 1/2 from non-qualified variable annuity contracts taken are not taxable to the recipient III The death benefit paid from a variable life policy is taxable to the recipient IV The death benefit paid from a variable life policy is not taxable to the recipient

I and IV Distributions taken at age 59 1/2 or later from variable annuity contracts are taxable as ordinary income to the extent that the distribution amount exceeds the premiums paid. In contrast, life insurance proceeds paid to a beneficiary are not taxable income to the beneficiary; nor are they taxable income to the recipient (a major benefit of life insurance). Note, however, that the insurance proceeds are included in the estate of the deceased individual and may be subject to estate tax.

If a variable life policyholder borrows against cash value, which statement is TRUE?

The amount borrowed is not taxable Taking out a loan against any asset is not taxable. This includes taking out a loan against the cash value of an insurance policy. Any amount of policy loan reduces the death benefit paid.

Howard paid premiums of $2,000 per year for 4 years on a $100,000 variable life policy. The AIR was set at 3% and the death benefit increased to $105,000. After the fourth year, he surrendered the policy and received its cash value of $9,200. What is the amount of gain Howard must report for federal income taxes in the year of the surrender?

$1,200 Howard paid premiums of $2,000 per year for four years for a total of $8,000. This is his cost basis in the contract. The amount Howard received on surrender is $9,200. The taxable gain is $1,200.

All of the following statements concerning the income tax treatment of cash value life insurance are correct EXCEPT:

realized capital gains are taxable to the policyholder during the life of the policy Neither unrealized nor realized capital gains are taxable during the life of the policy. Investment income is also not taxable during the life of the policy. The payment of a death benefit is not subject to income tax to the recipient nor the estate. However, the dollar value of the death benefit is included in the estate for estate tax purposes. A loan against any asset, including cash value insurance, is not income, so there is no income tax due. The amount of the loan reduces the death benefit.

George paid $3,000 annually in premium on a $150,000 variable life insurance policy, and then made a withdrawal of $15,000 after 10 years. The policy's cash value was $58,000 at the time of the withdrawal. How much of the withdrawal was taxable gain to George?

0 Partial withdrawals from a variable life policy are taxed completely opposite to withdrawals from variable annuities. The first monies out of an annuity contract are the tax-deferred build-up (taxable dollars), and the last dollars out are the return of premiums paid (non-taxable cost basis). This is LIFO taxation, which is a disadvantage to the client since the first dollars out of a variable annuity contract that is surrendered are taxable. The first monies out of an insurance contract due to a partial surrender are the return of premiums paid (non-taxable cost basis) and the last dollars are the tax-deferred build-up (taxable dollars). This is FIFO taxation, and this is a real tax advantage for the client since the first dollars out of a variable life insurance policy that is surrendered are not taxable! For this variable life policy, George paid $3,000 per year for 10 years = $30,000 in total premiums. Any withdrawal up to this amount is a non-taxable return of premiums paid.

Which of the following statements are correct concerning advantages to policy owners of variable life policies? I Income tax is deferred on dividends, interest, and capital gains the separate account earns II The policy owner can choose investments to meet objectives III The policy owner can borrow all of the cash value

I & II only Dividends, interest, and capital gains accumulate tax-deferred for the life of any insurance policy with an investment feature. This includes whole life, variable life, universal life, and variable universal life. Variable and variable universal life offer the advantage to policy owners that they can choose among investment options, so they can select investments compatible with their financial objectives. Since whole life and universal life premiums are invested in the insurance company's general account, there are no investment options with these policies. Policy owners may borrow only a portion of the cash value (typically 75-90%) of variable policies, not all of it, because the value of the securities held in the separate account can fluctuate. In contrast, 100% of cash value can be borrowed from a whole life or universal life policy.

For a surrendered variable life policy, what is the cost basis for federal income tax purposes?

The total amount of premiums paid by the owner Upon surrender of a variable life insurance policy, the cost basis used for calculating gain is the amount of premiums paid by the owner. Any proceeds paid by the insurance company upon surrender in excess of the cost basis are taxable as ordinary income.

Your client purchased a variable life insurance policy more than 15 years ago. The client died several weeks ago. Her son and beneficiary, Rich, comes to see you about the policy. The client had not taken any distributions from the policy and the premium payments are current. As both the executor of his mother's estate and beneficiary of the variable life policy, Rich asks you about the income tax treatment for the death benefit of the policy and about the amount of the death benefit on the account. You should tell Rich all of the following EXCEPT:

"The death benefit paid to a beneficiary is taxable income for the beneficiary" A death benefit paid to a beneficiary is not taxable income to the beneficiary. However, the amount of the death benefit proceeds are included in the insured person's estate, and are subject to federal estate tax (this assumes that the insured person is the owner of the policy). If the policy is in force when the policyholder dies, investment earnings are not subject to income tax, either to the estate or the beneficiary. This is a major benefit of life insurance. Finally, estate taxes are based on the dollar value of the estate (and remember that the insurance proceeds are included in the estate). There is an exclusion amount and then any estate value above this is taxable.