Unit 10 Quiz
Frank owns and is insured by a participating whole life insurance policy with a death benefit of $85,000, including $35,000 of paid-up additions to the face amount. His basis in the policy is $30,000. The beneficiaries are his daughter and son, equally. If he were to die today, what amount of this policy would be valued in Frank's estate? A) 85000 B) 50000 C) 0 D) 55000
85000 Explanation Life insurance owned by the insured is included, at its full death benefit amount, in the insured's estate at death for estate valuation purposes.
Under an executive bonus plan, the amount of premiums paid is A) taxable to the business and the employee B) taxable income for the employee C) taxed as a corporate business expense D) not taxed and treated as deferred income
taxable income for the employee Explanation Under an executive bonus plan, the premiums are tax deductible for the business and are considered employee compensation. The premium, since it is considered compensation, is taxable income for the employee.
Which the following statements regarding 1035 exchanges is NOT correct? A) Life insurance to annuity transfers are not taxable. B) Life insurance to life insurance transfers are not taxable. C) Annuity to annuity transfers are not taxable. D) Annuity to life insurance transfers are tax-free.
Annuity to life insurance transfers are tax-free. Explanation Annuity to life insurance transfers do not qualify under 1035 exchange rules, so any annuity gains would be taxable.
Which of the following business life insurance premiums is tax deductible to the business? A) Key-person life insurance policies B) Life insurance policies that reimburse the business for benefits paid under deferred compensation plans C) Buy-sell agreements funded by life insurance policies D) Executive bonuses
Executive bonuses Explanation Premiums are tax deductible to a business for executive bonuses because they are considered part of the employee's compensation. The other 3 are not tax deductible because financial benefits are derived by the business.
Which of the following statements regarding business life insurance policies is NOT true? A) Death benefits are not taxable. B) Key-person life insurance policies are not deductible to the business. C) Premiums are tax deductible, except for executive bonus plans. D) Premiums for executive bonus policies are taxable income to the employee.
Premiums are tax deductible, except for executive bonus plans. Explanation In general, business life insurance policies are not deductible to the business. However, executive bonus plans are considered compensation and are deductible to the business, and the bonus used to pay the premium is taxable to the employee.
As a beneficiary, Kathryn receives $800 monthly from her deceased spouse's life insurance under a fixed-amount option. Each payment consists partly of principal (proceeds) and partly of interest. How is this income taxed? A) The portion of each payment consisting of interest is taxed; the remainder is tax-free. B) The portion of each payment consisting of principal is taxed; the remainder is tax-free. C) Each payment is fully taxed. D) Each payment is received fully tax-free.
The portion of each payment consisting of interest is taxed; the remainder is tax-free. Explanation The monthly payment to the beneficiary under the fixed-amount option is considered a partially taxable installment (similar to an annuity payment). A fixed, unchanged portion of each payment is considered a return of principal and is therefore not taxed. The balance, however, is taxable as interest income.
When a cash value life insurance policy is converted into an annuity in a nontaxable transaction, the event is generally known as A) a 1035 exchange B) a modified endowment C) a rollover D) a pension enhancement
a 1035 exchange Explanation Section 1035 of the Internal Revenue Code provides for tax-free exchanges of certain kinds of financial products, including the exchange of life insurance for annuity contracts.
Juan names his sister, Silvia, as the beneficiary of his $250,000 life insurance policy. At Juan's death, if Silvia chooses to have the proceeds paid over time, rather than in a lump sum, A) none of the proceeds will be taxable as long as Silvia rolls them into a permanent life insurance policy B) the original death benefit is taxable and the interest is tax-free C) the original death benefit is not taxable; however, interest earned is taxable as ordinary income to Silvia D) the entire death benefit will be taxed
the original death benefit is not taxable; however, interest earned is taxable as ordinary income to Silvia Explanation If death benefits are not taken as a lump-sum payment, then the beneficiary will be taxed on the interest as ordinary income. The original death benefit is not taxable.
Cal, age 57, owns a whole life insurance policy with a $750,000 face amount that was paid for with a single premium of $100,000. The current cash value is $125,000. If he were to borrow $30,000 from this policy today, which of the following choices best describes the tax treatment this transaction will receive? A) $25,000 of the loan is subject to income taxation plus an additional 10% penalty tax. B) The first $25,000 of the loan is tax-free, but the remaining $5,000 is subject to income taxation. C) The loan is income tax-free. D) The first $5,000 of the loan is tax-free, and the remaining $25,000 is subject to income taxation.
$25,000 of the loan is subject to income taxation plus an additional 10% penalty tax. Explanation This policy is a modified endowment contract (MEC), evidenced by the fact that it was paid for with a single premium. Accordingly, all withdrawals, including loans, above the cost basis (the total amount of premium paid in) are subject to income taxation and, if the owner is under age 59½, an additional 10% penalty.
Which of the following statements regarding 1035 exchanges is NOT correct? A) A universal life insurance policy may be exchanged for a fixed deferred annuity tax-free, and the deferred annuity thereafter becomes subject to regular annuity taxation rules. B) A life insurance policy that is a modified endowment contract (MEC) may be exchanged for a new life insurance policy and, provided that premiums are paid for at least 7 years thereafter, no longer be considered a ME C) In order for an exchange of policies to qualify for Section 1035 treatment, the exchange of policy values must be made directly between insurers. D) A deferred annuity may be exchanged for an immediate annuity with no immediate tax consequences, but annuity benefit payments are subject to taxation under annuity taxation exclusion ratio rules.
A life insurance policy that is a modified endowment contract (MEC) may be exchanged for a new life insurance policy and, provided that premiums are paid for at least 7 years thereafter, no longer be considered a ME Explanation Once a MEC, always a MEA life insurance policy that is a MEC may be exchanged tax-free under Section 1035, but the new policy retains the MEC label.
Which of the following statements about annuities is NOT correct? A) The withdrawal rule on annuity cash value is FIFO. B) Annuities may be appropriate investments for both individuals and corporations. C) The 10% penalty tax is imposed on the interest earned and withdrawn, not on the principal. D) The 10% penalty tax on early distributions does not apply to distributions made to the annuity owner after separating from service from the employer after the owner reaches age 59½.
The withdrawal rule on annuity cash value is FIFO. Explanation The withdrawal rule on annuity cash value is LIFO: last in, first out. This means if the policyowner takes a withdrawal, the company will give the owner interest first, which is taxable at the insured's individual income tax bracket. If the owner is not at least 59½ years old at the time of withdrawal, a 10% penalty will also be assessed to taxable dollars withdrawn. The owner never pays taxes on withdrawing the cost basis or the money paid into the annuity.
Which of the following statements regarding nonqualified annuities and their tax treatment is NOT correct? A) Premiums are tax deductible. B) Interest earnings accumulate tax deferred and are taxed when distributed. C) Nonqualified annuities are LIFO contracts, meaning that the last money credited (interest earned) is the first money distributed in a withdrawal. D) The 10% early withdrawal tax penalty is waived if the owner is disabled.
Premiums are tax deductible. Explanation Nonqualified annuities are funded with after-tax dollars that accumulate tax deferred until distributions occur. Those distributions are on a LIFO basis. If a contract is annuitized, part of the distribution will be returned as principal.
Life insurance proceeds are included in the gross estate if A) the beneficiary is a family member B) the policy is trust owned and controlled C) the owner paid premiums with after-tax dollars D) the proceeds are payable to the insured's estate or the insured had any incidence of ownership in the policy at time of death or transferred ownership within 3 years of death
the proceeds are payable to the insured's estate or the insured had any incidence of ownership in the policy at time of death or transferred ownership within 3 years of death Explanation Proceeds from life insurance death benefits are included in the gross estate of the owner if she had ownership at the time of death; if her estate is her beneficiary, regardless of the owner; or if ownership was been transferred within 3 years of her death.
Maureen, age 62, owns a non-MEC whole life insurance policy with a death benefit of $200,000 and a cash value of $40,000. Her basis in the policy is $25,000. If she were to borrow $30,000 from this policy and then die immediately thereafter (without having repaid any portion of the loan), which of the following best describes the resulting tax treatment of the policy's death benefit? A) The full $200,000 will be paid to the beneficiary, all of which is income tax-free. B) The full $200,000 will be paid to the beneficiary, but $30,000 of that amount will be subject to income taxation. C) $170,000 will be paid to the beneficiary, all of which is income tax-free. D) $170,000 will be paid to the beneficiary, but $5,000 of that amount will be subject to income taxation.
$170,000 will be paid to the beneficiary, all of which is income tax-free. Explanation Except in the case of a MEC, life insurance policy loans are income tax-free. If the insured policyowner dies before the loan is repaid, the death benefit is reduced by the outstanding loan balance, with no income tax consequences.
In which of the following situations would premium payments be tax deductible? A) Randy is the owner and premium payor of a life insurance policy covering his spouse. B) A company provides $25,000 of life insurance coverage to each of its 15 employees and pays the full premium. C) A company is the owner and premium payor of a $250,000 key-executive policy covering the life of its president. D) Janet is the owner and premium payor of a mortgage policy that covers the outstanding mortgage on her home.
A company provides $25,000 of life insurance coverage to each of its 15 employees and pays the full premium. Explanation Premiums paid by a company for group term life insurance are deductible as a business expense, assuming the group plan and its provisions meet the necessary requirements. Premiums paid for personal life insurance are not tax deductible, including key-person insurance.
Archibald surrenders a life insurance policy and receives a lump-sum cash payment of $32,000. His premium payments up to the time of surrender amounted to $26,000. How is the surrender treated for tax purposes? A) Archibald will receive $6,000 tax-free and will be taxed on his $26,000 cost basis. B) The full $32,000 is received tax-free. C) The full $32,000 is taxable as ordinary income. D) Archibald will receive his $26,000 cost basis tax-free and will be taxed on $6,000.
Archibald will receive his $26,000 cost basis tax-free and will be taxed on $6,000. Explanation Archibald will be taxed on the amount that exceeds the $26,000 he paid into the policy's cost basis.
Annuity payments are taxable to the extent that they represent interest earned rather than capital returned. What method is used to determine the taxable portion of each payment? A) Annuitization ratio B) Marginal tax formula C) Surtax ratio D) Exclusion ratio
Exclusion ratio Explanation An exclusion ratio is applied to each benefit payment the annuitant receives to determine the amount that is excluded from taxation: investment in the contract is equal to the exclusion ratio divided by the expected return. The investment in the contract is the amount of money paid into the annuity. The expected return is the annual guaranteed benefit the annuitant receives, multiplied by the number of years she will receive benefits.
Kelly, age 48, owns a universal life insurance policy (non-MEC) with a current death benefit of $270,000 and a cash value of $20,000. Her basis in the policy is $12,000. Kelly is interested in either borrowing or withdrawing $15,000 from this policy. What would be the tax consequences if she were to borrow the $15,000 through a policy loan? A) Of the amount borrowed, $12,000 would be income tax-free, $3,000 would be subject to income taxation, and there would be an additional penalty tax. B) There would be no income taxation on any portion of the amount borrowed, whether or not she repaid the policy loan. C) Of the amount borrowed, $12,000 would be income tax-free and $3,000 would be subject to income taxation. D) There would be no income taxation on any portion of the amount borrowed, but if she did not repay the loan, $3,000 would be subject to income taxation.
There would be no income taxation on any portion of the amount borrowed, whether or not she repaid the policy loan. Explanation Except in the case of a MEC, life insurance policy loans are income tax-free.
Betty purchased a universal life insurance policy when she was 61. Upon her 66th birthday, she received sizable inheritance, paid an exceptionally large annual premium and, in doing so, violated the 7-pay test. The following year, hoping to correct the situation, she made no premium payment so that the average premiums paid were less than the 7-pay test average. Today the policy's cash value stands at $45,000, and her basis in the contract is $28,000. If she were to withdraw $30,000 from the policy's cash value, which of the following best describes the tax treatment this transaction would receive? A) $28,000 of the distribution is tax-free, but $2,000 is subject to income taxation. B) The entire distribution is income tax-free. C) The entire $30,000 distribution is subject to income taxation. D) $13,000 of the distribution is tax-free, but $17,000 is subject to income taxation.
$13,000 of the distribution is tax-free, but $17,000 is subject to income taxation. Explanation This policy became a modified endowment contract (MEC) the moment it violated (and did not immediately correct) the 7-pay test. Once a policy becomes a MEC, it cannot lose that status. As such, pre-death distributions are treated first as a distribution of (income-taxable) gain, which in this case is $17,000.
With regard to the taxation of life insurance policies, which of the following statements is CORRECT? A) Amy owns a participating life insurance policy on her own life. She can deduct the premium payments, but she will be taxed on any dividends the policy may pay. B) Donita has taken a policy loan to use as collateral for a loan. The amount of the loan is taxable. C) Terry owns a 10-year-old whole life insurance policy, which she surrenders for cash. She will be taxed on the full amount she receives, since the policy did not mature. D) As long as a whole life policy is not surrendered, the cash value accumulates tax deferred.
As long as a whole life policy is not surrendered, the cash value accumulates tax deferred. Explanation Premiums for individual life insurance, dividends paid on participating policies, and policy loans are not taxable to a policyowner. With policy surrenders, any gain in the cash value is taxable to the extent that the amount received exceeds the total amount of premiums paid by the policyowner.
Which of the following statements regarding the estate tax treatment of life insurance owned by the insured at the insured's death is NOT correct? A) The insured could keep death benefit proceeds out of his estate by making another party the owner of the policy. B) Life insurance that is owned by the insured will avoid estate tax inclusion as long as ownership is transferred to another party at least 1 year before the insured's death. C) An irrevocable life insurance trust is a common device used to keep life insurance out of the insured's estate. D) Life insurance death benefit proceeds are included in the insured's estate for estate valuation purposes if the policy was owned by the decedent.
Life insurance that is owned by the insured will avoid estate tax inclusion as long as ownership is transferred to another party at least 1 year before the insured's death. Explanation Life insurance owned by the insured is included, at its full death benefit amount, in the insured's estate at death for estate valuation purposes. An insured can avoid this by transferring existing policies to another party (e.g., an irrevocable life insurance trust) at least 3 years before the insured's death.
Mary, age 70, recently purchased a nonqualified immediate annuity to supplement her retirement income, and through it will receive a lifetime income of $800 per month. Which of the following statements most correctly describes how this income will be taxed? A) Mary will pay income tax each year on just a portion of the payments received, and when she has fully recovered her basis, all future payments will be taxable. B) Mary will pay income tax on the full amount received each year until the sum of payments equals the amount she paid for the annuity (her basis), at which point all future payments will not be taxed. C) Mary will not pay income tax until the sum of payments received equals her basis, at which point all future payments will be fully taxable. D) Mary will pay income tax each year on just a portion of the payments received, and when she has fully recovered her basis, all future payments will not be taxed.
Mary will pay income tax each year on just a portion of the payments received, and when she has fully recovered her basis, all future payments will be taxable. Explanation How benefits will be taxed in retirement will always be an important part of any senior planning. The exclusion ratio calculation identifies the amount of each annuity payment that is a tax-free return of basis. The remaining amount of each annuity payment is taxable as ordinary income. Once the annuity's cost basis is fully returned, however, the full amount of any further payments is fully taxable.
Which of the following statements best describes the general tax treatment of life insurance pre- and post-death distributions? A) Most pre- and post-death distributions from a life insurance policy are income tax-free, but they may be subject to AMT. B) All distributions from a life insurance policy at the insured's death are income tax-free, but pre-death distributions are subject to income taxation. C) Most distributions from a life insurance policy at the insured's death are income tax-free, but pre-death distributions may be subject to income taxation if the withdrawal exceeds premiums paid. D) Most pre- and post-death distributions from a life insurance policy are subject to income taxation to the extent there is gain in the policy.
Most distributions from a life insurance policy at the insured's death are income tax-free, but pre-death distributions may be subject to income taxation if the withdrawal exceeds premiums paid. Explanation Most distributions from a life insurance policy at the insured's death are income tax-free, but pre-death distributions are subject to income taxation to the extent there is gain in the policy. The death benefit of a policy that is subject to transfer-for-value rules may be subject to income taxation, so it is not correct to say all policies enjoy a tax-free death benefit.
Bill names his church as the beneficiary of his $300,000 life insurance policy. When Bill dies, who is responsible for the income taxes payable on the lump-sum proceeds received by the church? A) Bill's estate and Bill's church split the tax B) Bill's estate C) No income tax is payable on the death proceeds D) Bill's church
No income tax is payable on the death proceeds Explanation Lump-sum proceeds payable upon the insured's death are not subject to income tax, no matter who the beneficiary is.
Sidney, age 58, owns a deferred variable annuity that he purchased 15 years ago and into which he has paid $25,000 in the form of periodic premiums. Today its cash value is $37,000. If he dies today, which of the following statements best describes the tax treatment this transaction will receive? A) Of the cash value, $25,000 is payable to the beneficiary income tax-free, $12,000 is subject to income taxation, and there is a penalty tax. B) Of the cash value, $12,000 is payable to the beneficiary income tax-free and $25,000 is subject to income taxation. C) Of the cash value, $25,000 is payable to the beneficiary income tax-free and $12,000 is subject to income taxation. D) The full $37,000 is payable to the beneficiary income tax-free.
Of the cash value, $25,000 is payable to the beneficiary income tax-free and $12,000 is subject to income taxation. Explanation There are no tax-free death benefits associated with annuities, as there are with life insurance. The portion of the cash value death benefit that constitutes gain is subject to income taxation. Because the payout is the result of death, there is no early withdrawal penalty tax.
Ralph owns a $50,000 nonparticipating whole life policy. Its cash value has accumulated to $15,000, and he has paid a total of $9,500 in premiums. If he surrenders the policy for its cash value, how will it be taxed? A) Ralph will receive $9,500 tax-free; the $5,500 balance is taxable as income. B) Ralph will receive the $15,000 as taxable income. C) Ralph will receive the $15,000 tax-free. D) Ralph will receive $5,500 tax-free; the $9,500 balance is taxable as income.
Ralph will receive $9,500 tax-free; the $5,500 balance is taxable as income. Explanation A policyowner is allowed to receive tax-free an amount equal to what he paid into the policy over the years in the form of premiums. Any gains are taxable.
