2. Insurance Planning. 12. Taxation of Insurance Flashcards
Module Introduction
What is the common thread between a gift and a life insurance policy? Seemingly, there is no connection. But upon closer inspection, there is more to both than meets the eye. A life insurance policy can be a great gift for those that need protection from the financial devastation that often accompanies loss of life. Moreover, a life insurance policy can be gifted to someone, and help the person save on taxes. So, the next time someone asks you what gift they should get for a loved one, you might want to suggest they consider purchasing life insurance.
Insurance is intrinsically related to taxation issues, as insurance policies have a direct bearing on taxation. For example, in the U.S. the dividends of an insurance policy from a mutual life insurance company are exempt from federal taxation.
The Taxation of Insurance module will explain the taxation of life insurance, gift tax, and estate tax in detail.
The online portion of this module takes the average student approximately two and a half hours to complete.
Upon completion of this module you should be able to:
* Explain the taxation of life insurance,
* List the benefits of life insurance taxation,
* Discuss the gift tax law and its exclusions,
* List the benefits of the gift tax law,
* Explain the benefits of gifting an insurance policy,
* Explain federal estate tax, and
* Taxation of health insurance.
Module Overview
Premium payments for individually purchased life insurance are not deductible from a person’s federal income tax, but when the beneficiary receives the proceeds of a life insurance policy, no federal income tax applies.
The taxation of life insurance includes benefits of early withdrawal of death benefits in cases where the insureds are terminally ill. Even dividends received from a mutual life insurance company are not subject to federal income tax.
The federal estate tax is a tax on a person’s right to transfer property on his or her death. Although not a tax on the property itself, it is calculated on the value of such property. The difference between estate tax and gift tax is that the former is applicable to those transfers that take place when a property owner dies, whereas the latter is applicable to those transfers that take place during the property owner’s lifetime.
To ensure that you have an understanding of the taxation of insurance, the following lessons will be covered in this module:
* The Taxation of Life Insurance
* The Gift Tax Law
* Estate Tax Treatment
Section 1 – Taxation of Life Insurance
In general, premium payments for individually purchased life insurance policies are not deductible from a person’s federal income tax, and when the beneficiary receives the proceeds of a life insurance policy, no federal income tax applies.
For estate tax purposes, if the insured is also the owner on the policy, the death proceeds are included in their gross estate and may be subject to the estate tax. If a person owns a policy on another person’s life, only the replacement cost of the policy at the time of the owner’s death is included in his or her estate.
To ensure that you have an understanding of Taxation of Life Insurance, the following topics will be covered in this lesson:
* Death Proceeds
* Living Benefits
Upon completion of this lesson, you should be able to:
* Discuss the income tax treatment of life insurance, and
* Discuss the estate tax treatment of life insurance.
If an insured with a $100,000 life insurance policy died after $3,000 of premiums had been paid, what amount of the death proceeds would be received tax-free by the beneficiary?
* $30,000
* $50,000
* $3,000
* $100,000
$100,000
* The entire $100,000 would be received income tax free by the beneficiary.
* With exceptions, this result applies irrespective of the cash value of the amount of premiums paid and regardless of who was listed as the policy owner, insured, beneficiary, or premium payor.
Practitioner Advice:
Describe Incidents of Ownership and Taxation
Incidents of ownership include any economic benefit in a life insurance policy. A life insurance policy owner has incidents of ownership in the policy that may include the right to borrow against the policy, assign or transfer the policy, receive cash values and dividends or change the beneficiaries. Retaining any incidents of ownership in a policy causes the death benefit to be included in the insured’s estate, which may be subject to estate tax. Inclusion occurs even if the policy is transferred to a new owner or to a trust more than three years before the insured’s death if any incidents of ownership are retained.
Now, assume instead that six years ago John transferred all ownership rights in the life insurance policy to his wife Abigail, not to Fred, and that he died this year. In this case, the life insurance proceeds would not be included in John’s estate because he did not own the policy or have any incidents of ownership at his death, and he had transferred the policy more than three years before he died. If Abigail had died before John, however, then the value of the policy at the time of her death – the replacement cost value – would be included in her estate. Fred as beneficiary would owe no federal income tax on the proceeds he received, but his mother (as policy owner who is not the insured) would have given him a $1 million gift of the proceeds.
This complication is one reason why people often use irrevocable trusts to own life insurance as part of their estate plans. If, however, the gross estate is below the lifetime applicable exclusion amount, there will be no federal income tax or estate tax due, and therefore, perhaps no need to create an irrevocable life insurance trust (ILIT).
Practitioner Advice: Remember, estate taxation is not the same as income taxation. The beneficiary will generally receive the death proceeds without having to pay any income taxes on those funds. Also, if the beneficiary has no incidents of ownership in the policy, his or her estate will not need to include any policy values upon death.
Also, although there may be no federal estate tax consequences, there may be state estate tax liabilities due to lower limits than the $12,920,000 (2023) federal exemption and inheritance taxes.
Assume Kuramo names his son, Abeo, the beneficiary of his $1 million life insurance policy and transfers the policy to him six years before his death.
If Kuramo retained the right to change the beneficiary, the $1 million death benefit will be included in which estate?
* Kuramo’s
* Abeo’s
* Neither estate
Kuramo’s
* At Kuramo’s death the $1 million in death proceeds are included in Kuramo’s estate since he retained the right to change the beneficiary.
* Although Kuramo transferred the policy to Abeo more than three years before his death, this incident of ownership causes the death benefit to be included in Kuramo’s estate.
Death proceeds include the policy face amount and may which of the following?
* Any additional insurance amounts paid by reason of the insured’s death.
* Accidental death benefits.
* The face amount of any paid-in-full additional insurance.
* The face amount of any term rider.
Any additional insurance amounts paid by reason of the insured’s death.
Accidental death benefits.
The face amount of any paid-in-full additional insurance.
The face amount of any term rider.
* Death proceeds include the policy face amount and any additional insurance amounts paid by reason of the insured’s death, such as accidental death benefits and the face amount of any paid-in-full additional insurance or any term rider.
If the insured withdraws the savings value of the insurance and if this value exceeds the insured’s adjusted basis, the excess is subject to federal income tax in the year of the withdrawal.
* False
* True
True
* if the insured withdraws the savings value of the insurance and if this value exceeds the insured’s adjusted basis, (premiums paid less dividends received), the excess is subject to federal income tax in the year of the withdrawal.
Under the transfer for value rule the death benefit amount that exceeds the new policy owner-beneficiary’s adjusted basis is subject to income tax at __ ____??____ __ rates when the insured dies.
* ordinary income
* capital gains
* estate tax
* generation skipping transfer tax
ordinary income
* Under the transfer for value rule the death benefit amount that exceeds the new policy owner-beneficiary’s adjusted basis is subject to income tax at ordinary income rates when the insured dies.
* The transfer for value rule cannot be avoided by cancelling the transaction at a later time.
Under Section 1035(a), no gain or loss shall be recognized on the exchange of a life insurance policy to which of the following: (Select all that apply)
* Life insurance contract
* Endowment contract
* Annuity policy
* Appreciable property
Life insurance contract
Endowment contract
Annuity policy
Under Section 1035(a), no gain or loss shall be recognized on the exchange of the following insurance policies:
* A contract of life insurance for another contract of life insurance or for an endowment or annuity contract; or
* A contract of endowment insurance (A) for another contract of endowment insurance which provides for regular payments beginning at a date not later than the date payments would have begun under the contract exchanged, or (B) for an annuity; or
* An annuity contract for an annuity contract.
Section 2 – Gift Tax
A life insurance policy by itself makes a great gift. Gifts can be comprised of life insurance or annuities utilizing the contract itself, premium payments and/or proceeds. Along with the gifting of insurance products comes the possibility of a gift tax.
In a bid to regulate gift tax, the IRC had provided for a generation-skipping transfer (GST) tax to be levied when a property interest was transferred to persons who were two or more generations younger than the transferor. The GST tax was intended to ensure that transfer taxes were paid by wealthy persons who might otherwise avoid a generation of transfer taxes by passing their property directly to their grandchildren. The GST exemption for 2023 is $12,920,000.
The federal gift tax is imposed upon the right to transfer property to another person. The federal gift tax law is not aimed at the usual exchange of gifts associated with birthdays, holidays, and such occasions.
When a married individual makes a gift to someone other than a spouse, it may be regarded as being made one-half by each spouse. The gift tax marital deduction permits tax-free transfers between spouses.
To ensure that you have an understanding of gift tax, the following topics will be covered in this lesson:
* Gift Tax Law
* Gift-Splitting Privilege
* Gift of Life Insurance and Annuities
* Generation-Skipping Transfer Tax
Upon completion of this lesson, you should be able to:
* Explain gift tax law and its exclusions
* List deductions under gift tax schemes, and
* Explain why a life insurance policy is a good gift.
If Brashad gives $9,000 to Jamal and $11,000 to Omar, then he can exclude __ ____??____ __ for gift tax purposes.
* $15,000
* $20,000
* $30,000
* $11,000
$20,000
* The $17,000 (2023) gift tax exclusion is the maximum gift tax-free amount, applied on a per person basis.
* A $9,000 gift to Jamal and a $11,000 gift to Omar are each below the $17,000 limit.
* Therefore, a total of $20,000 ($9,000 + $11,000) in gifts are tax-free to Brashad.
Section 2 – Gift Tax Summary
The federal gift tax is incurred when property is transferred to another person. The gift tax law provides for benefits like gift tax exclusions, gift-splitting privileges and gift tax marital deductions for married individuals, and the right of gifting insurance policies and annuities to facilitate tax-free transfers or benefits.
In this lesson, we have covered the following:
- Federal Gift Tax Law is imposed upon the right to transfer property to another person, and does not include the ordinary exchange of gifts associated with occasions like birthdays and holidays.
- The Gift Tax Law is calculated by adding all the donor’s lifetime taxable gifts. A unified rate schedule to the total taxable gifts is applied to derive the tentative tax. The unified tax credit is subtracted from this, to yield the gift tax payable in the current period.
- The Gift Tax Law benefits include gift-splitting privileges, deductions, gift of life insurance, gift of insurance contracts, gift of premiums, and gift of proceeds.
Robert Brown is married. He has a wife, Sarah, and a daughter, Jenny. He buys a policy in his name, and insures his wife and names his daughter as a beneficiary. At Sarah’s death, Jenny receives the life insurance death proceeds as a gift from Robert.
* True
* False
True
* Gifts occur when one person owns a policy, a second is insured, and the third is a beneficiary.
* Life insurance policies are not gifts under ordinary circumstances.
* A gift usually occurs from a policy owner to the beneficiary at the insured’s death.
Premiums paid by an insured are gifts if the insured:
* Does not own the policy and proceeds of the policy are payable to a beneficiary other than his estate.
* Does not own the policy but proceeds of the policy are payable to his estate.
* Owns the policy but proceeds of the policy are not payable to his estate.
* Owns the policy but wishes to pass on the proceeds of the policy to some charity.
Does not own the policy and proceeds of the policy are payable to a beneficiary other than his estate.
* Premiums paid by an insured are gifts if the insured has no incidents of ownership in the policy and proceeds of the policy are payable to a beneficiary other than his or her estate.
* Premiums paid by a beneficiary on a policy that he or she owns are not gifts.
The federal gift tax is incurred if:
* A mother gifts a teddy bear worth $10 to her son on his birthday.
* If one sends a Christmas card worth $2 to a friend for Christmas.
* If a mother gifts her daughter a watch worth $19,000, in a specific year.
* If a mother gifts her son a watch worth $9,000, in a specific year.
If a mother gifts her daughter a watch worth $19,000, in a specific year.
* The federal gift tax law is not aimed at the usual exchange of gifts associated with birthdays, holidays and similar occasions.
* The law permits a donor to make a gift without tax by excluding the first $16,000 (2022) of outright gifts in any one specific year to any one recipient.
Section 3 – Estate Tax Treatment
The federal estate tax is assessed on a person’s right to transfer property at the time of his or her death. Not a tax on the property itself, it is calculated on the value of such property.
There is a fundamental difference between estate tax and gift tax. The estate tax is applicable to those transfers that take place when a property owner dies, whereas the gift tax is applicable to those transfers that take place during the property owner’s lifetime.
To ensure that you have an understanding of estate tax treatment, the following topics will be covered in this lesson:
* Federal Estate Tax
* Taxation of Health Insurance
Upon completion of this lesson, you will be able to:
* Explain Federal Estate Tax and the conditions for filing its returns,
* List the benefits available under Federal Estate Tax, and
* Explain the medical insurance and long-care benefit under the Federal Estate Tax.
Practitioner Advice:
Describe the Federal Estate Tax
The estate tax, introduced at a modest level in 1916, can have a great impact on wealthy estates.
The federal estate tax is arrived at by adding the taxable estate to adjusted taxable gifts, which are taxable gifts made after 1976, to yield the tentative tax base. The reason for this addition is that the estate tax law is part of a unified transfer tax law that applies to transfers made at death and even during life. It is necessary to add the value of lifetime taxable transfers (gifts) back to the tax base to derive the appropriate marginal tax bracket. The appropriate tax rate is then applied to the tentative tax base to derive the tentative federal estate tax. From this tentative tax is subtracted certain credits for gifts and other taxes paid as well as the unified credit.
Generally, a federal estate tax return must be filed and any estate taxes paid within nine months of the death of any U.S. citizen or resident who leaves a gross estate of more than a specified exempted amount. The exempted amount in 2023 is $12,920,000.
An extension of up to 10 years may be granted for payment of taxes by the IRS for “reasonable cause,” including those taxes associated with certain closely held businesses.
The federal estate tax is a graduated tax, starting at 18 percent and building to a 40 percent marginal rate for taxable amounts over $12,920,000 in 2023.
The gross estate, the starting point for estate tax computation, consists of the value of the decedent’s interest in all property. Allowable deductions are then subtracted from the gross estate, which results in the taxable estate. However, the unified credit is a tax credit that can be applied to offset the taxable estate.
Practitioner Advice: In the past, people focused their estate planning strategies primarily on federal tax laws. Now that Congress has reduced the federal estate tax, many states have revised their laws so that they can continue to collect taxes. In some states (e.g., Massachusetts), there may be state taxes owed on estates that are exempt from federal estate tax.
