Chapter 10

Question 1

What two questions relate to tax treatment regarding annuities?

Answer 1

1. Is the premium tax-deductible or not?

2. Are distributions from insurance product taxable or not

Question 2

Are premiums paid for individual life insurance tax deductible?

Answer 2

No

Question 3

how are interest payments credited to life insurance treated?

Answer 3

They are tax-deferred

Question 4

When a life insurance policy is surrendered, how are gains taxed?

Answer 4

The gains are taxable (Gain = Cash value - policy’s cost basis)

So cash value accumulations are tax deferred, but not necessarily tax-free

Question 5

How are withdrawal’s (partial surrenders) taxed?

Answer 5

They are taxable to the extent of any gain

-THey are taxed on a FIFO basis (meaning, the assumption is that anything withdrawn is considered to come from the premiums paid (cost basis) FIRST and cost basis withdrawals are not taxable

Question 6

Any money received from a policy, other than the death benefit, does what to the death benefit?

Answer 6

It reduces the cost basis

Question 7

Are policy loans taxable?

Answer 7

No - even if the amount exceed’s the policy’s cost - the basis. The amount of the loan never becomes taxable even when the insured dies

Question 8

If a policy is surrendered or it lapses while there is a policy loan outstanding, any portion of the loan amount that exceeds the policy’s cost basis is what?

Answer 8

A taxable gain

Question 9

Is interest paid on a policy loan tax-deductible?

Answer 9

No

Question 10

Are dividends from policies taxable?

Answer 10

No (assumed to be return of a portion of premiums)

Question 11

Do dividends reduce the cost basis?

Answer 11

Yes (recall, they are a return on principal - which is why they are not taxable)

Question 12

While dividends are not taxable, if they are left to accumulate interest, is the interest taxable?

Answer 12

Yes

Question 13

When the entire death benefit amount “lump sum” is paid to a named beneficiary, is it taxable?

Answer 13

No - it is not taxable in that case. Whether the policy is owned by an individual or a business

Question 14

If a death benefit payment is made under other settlement options, not a “lump-sum”, how is it treated for tax purposes?

Answer 14

1. The original death benefit is not taxable

2. Interest earned on the proceeds are taxable as ordinary income when paid to the beneficiary

Question 15

What are accelerated death benefits?

Answer 15

An advance of death benefits - written certification from a physician is required, diagnosing a qualifying even that will substantially decrease the insured’s life span

Question 16

What do “qualifying events” include?

Answer 16

Terminal illnesses expecting to end in death within 24 months, acute illness, emergency organ transplants, permanent confinement to nursing homes, and long-term care (if activities of daily living can no longer be performed). Part or all of the death benefit may be us

Question 17

With qualifying events, can part or all of the death benefit be used?

Answer 17

Yes

Question 18

Are accelerated death benefits tax exempt?

Answer 18

Yes

Question 19

What three types of business life insurance are not tax deductible to the business?

Answer 19

1. Key person life insurance policies
2. Life Insurance policies funding buy-sell agreements
3. Life insurance policies that will reimburse the company for benefits paid under deferred compensation plans

Question 20

Why are key person, buy-sell agreements, and life insurance policies that will reimburse the company for benefits paid under deferred compensation plans not tax deductible for businesses?

Answer 20

Because the business receives financial benefits from owning these policies

Question 21

Are premiums paid by the company for executive bonuses tax deductible?

Answer 21

Yes (as such, the amount of premium paid is also considered taxable income to the employee)

Question 22

With contributory group plans, is the employee portion of the group life insurance premium tax deductible?

Answer 22

No

Question 23

Group life insurance premiums paid by the employer are tax-deductible as a business expense provided under an employer group benefit plan

Answer 23

Note

Question 24

With group life insurance plans, is the premium for the first $50,000 of coverage taxable to the employee?

Answer 24

No - the premium for the first $50,000 of coverage is not taxable to the employee

Question 25

With group life insurance plans, is the premium additional coverage above $50,000 taxable as income to the employee?

Answer 25

Yes

Question 26

What is the “modified endowment contract”?

Answer 26

A modified endowment contract, or a MEC, is a special type of life insurance under federal income tax law. Specifically, the law prescribes a test that is intended to differentiate between policies that are purchased primarily for certain tax advantages, versus policies that are purchased primarily for death protection

Question 27

MECs are still life insurance and offer tax-free death benefits and tax deferred cash value accumulation. If a policy becomes a MEC, and no distributions are taken from that policy during the insured’s lifetime, they will not experience any adverse tax implications due to the contracts MEC status

Answer 27

Note

Question 28

To determine if a contract is an MEC, what occurs?

Answer 28

A premium limit is set and is referred to as a seven-pay limit or MEC limit. Based on the annual premium that would pay up the policy after the payment of several level annual premiums

Question 29

What is the MEC test?

Answer 29

Under the MEC test, the cumulative amount paid at any time in the first 7 years cannot exceed the cumulative MEC limit applicable in that policy year

Question 30

If you fail the MEC test (cumulative premiums are higher than they should be), what is the policy classified as?

Answer 30

An MEC

Question 31

If you over-contribute premium, resulting in MEC status, what can you do to avoid having a policy become a MEC?

Answer 31

The insurer may refund excess premiums within 60 days to avoid having a policy become a MEC

Question 32

What is the MEC test known as?

Answer 32

The modified pay limit

Question 33

Withdrawals OR loans from MECs are taxed - t/f? LIFO or FIFO

Answer 33

True - on a LIFO basis (meaning, interest is taxed first)

Question 34

With MECs, does a penalty exist for interest withdrawn before age 59.5? How much?

Answer 34

Yes (10% penalty)

Question 35

Are annuity premiums tax-deductible?

Answer 35

No - unless the contract is held in a qualified retirement account

Question 36

How is interest credited to annuity accounts treated?

Answer 36

it is tax-deferred. They become taxable when they are paid out

Question 37

When does interest credited to an annuity become taxable?

Answer 37

When it is paid out

Question 38

Earnings on annuities owned by corporations are taxable when?

Answer 38

When they are credited

Question 39

Distributions from an annuity during the accumulation phase receive the same treatment as modified endowment account - t/f?

Answer 39

True - LIFO taxation (the entire taxable gain is received before any non-taxable cost basis

Question 40

With annuities, a 10% penalty tax must be paid in addition to the regular tax due on any taxable amount received. When does this penalty not apply?

Answer 40

When the individual is disabled

Question 41

What is the “exclusion ratio” for annuities?

Answer 41

The exclusion ratio is used to determine the nontaxable portion of each monthly payment. The formula is applied to each annuity payment to find the portion that is excludable from gross income. The remainder is taxed as ordinary income

Question 42

as an example of the “exclusion ratio” - an annuity owner paid $12,000 into a contract and its now worth $19,200. The exclusion ratio is $12,000/$19,200 or 62.5%. If the monthly payment received is $100, the portion that is excluded from gross income is $62.50 or 62.5% of $100. The $37.50 balance of each $100 monthly payment is ordinary income

Answer 42

Note

Question 43

After annuitization, is it true that annuity payments are “taxed according to the exclusion ratio”?

Answer 43

Yes

Question 44

Premiums Paid in / Total of expected payments over annuitants life expectancy = what?

Answer 44

% of payment NOT TAXED

Question 45

If an annuitant lives beyond his/her life expectancy, how much of the payment becomes taxable?

Answer 45

100%

Question 46

What are 4 different ways that annuity payments can be made at the death of an annuity owner to the beneficiary?

Answer 46

1. Lump-Sum
2. Five-Year withdrawal period
3. Annuity Payout
4. Spousal Option

Question 47

What is the “lump sum” payout of an annuity to a beneficiary? What is the tax treatment?

Answer 47

1. Beneficiary can take all of the proceeds at once

2. The gain is taxable

Question 48

What is a 5-year withdrawal period? What is the tax treatment?

Answer 48

The beneficiary must withdrawal all of the proceeds within 5 years. These withdrawals are taxed the same as withdrawals during the owner’s life. That is, the gain is taxable and all the gain must be taken out before any non-taxable cost basis is withdrawn (Evan - sounds like LIFO)

Question 49

what is an “annuity payout” option for delivery to a beneficiary? What is the tax treatment?

Answer 49

The beneficiary may take the proceeds under an annuity payout option. This option must be selected within one year of the owners death.

The payments are taxed as annuity payments - part taxable gain and part non-taxable cost-basis, with the non-taxable amount determined by the exclusion ratio

Question 50

What is the “spousal option” for delivery to a beneficiary? What is the tax treatment?

Answer 50

The beneficiary is the owner’s spouse. Ownership may be transferred to the spouse without any tax consequences

Question 51

If death occurs during the annuity period, tax treatment of any continuing payments depends on what?

Answer 51

Whether those payments are being made to a:

1. Survivor Annuitant
2. Beneficiary

Question 52

If payments are made to a survivor annuitant under a joint and survivor annuity, how are they taxed?

Answer 52

They are taxed as they were when made to both annuitants. If the entire cost basis has not yet been paid out, the amount excludable from taxable income remains fixed even if the payments to the survivor annuitant is reduced, such as under a joint and two thirds survivor annuity

Question 53

With a joint and survivor annuity, when do payments become fully taxable?

Answer 53

When the entire cost basis has been paid out

Question 54

If payments are made to a beneficiary under an annuity contract, how are those payments taxed?

Answer 54

The entire payment becomes non-taxable until the entire cost basis has been paid out (including the portion of cost basis that was paid to the annuitant). At that point, any remaining payments are fully taxable.

Question 55

If the entire cost basis had been paid out to the annuitant prior to death, how would annuity payouts be taxed to a beneficiary?

Answer 55

They would be fully taxable

Question 56

A gain in a life insurance contract is considered taxable when the policy is surrendered - t/f?

Answer 56

True

Question 57

What does section 1035 of the tax code allow?

Answer 57

Individuals to move cash from one contract to another without having any gain taxed at that time

Question 58

To quality for 1035 (transfer cash from one account to another without having any gain taxed at that time) what must be the case?

Answer 58

Insured and beneficiary must be the same between the two accounts

Question 59

The 1035 exchange applies to what 2 things?

Answer 59

1. Life Insurance

2. Annuities

Question 60

What movements of cash flows qualify under a 1035 exchange?

Answer 60

1. Life insurance policy to another life insurance policy
2. Annuity contract to another annuity contract
3. life insurance policy to an annuity contract

Question 61

Does an annuity to a life insurance contract qualify under a 1035 exchange?

Answer 61

No - The surrender of an annuity to move the cash values to a life insurance policy does not qualify as a 1035 exchange.

Question 62

Under an annuity to life transition (which does not qualify under a 1035 exchange), are the annuity gains taxable?

Answer 62

Yes

Question 63

When are estate taxes owed?

Answer 63

Estate taxes are owed if an estate’s value exceeds a certain value at the time of the individual’s death - and taxes are applied to the estate’s value

Question 64

When are life insurance policies counted as a value in a deceased’s insured estate (and thus subject to estate taxes)?

Answer 64

1. They are payable to the estate
2. The deceased possessed any incidents of ownership in the policy at the time of death - the right to name or change the beneficiary - the right to access cash values, the right to assign ownership of the policy to another party or
3. The deceased assigned or transferred ownership of the policy to another person with three years of death

Question 65

What is the estate tax treatment of annuities - (1) during the accumulation period?

Answer 65

If death occurs during the accumulation period, the entire value of the annuity - not just the gain, but also the cost basis - is included in the estate

Question 66

What is the estate tax treatment of annuities during the annuitization period?

Answer 66

the present value of any payments that will continue to a beneficiary or survivor annuitant is included in the estate