Chapter 7 Flashcards
Taxation of Personal Life Insurance
For individuals, premiums are considered a personal expense and are not deductible.
Employers do get tax-deductions as a business expense to the employer unless named as the beneficiary.
Employer paid premiums in connection with group life insurance shall not constitute taxable income to the employee unless the death benefit exceeds $50,000. All premiums for amounts above $50,000 are reported as taxable income.
Cost Recovery Rule
The cash value minus the sum of premiums paid equals equity. Owner is taxed on the contract equity for cash values.
Policy Loan Taxation
The interest paid on a personal loan from a cash value policy is not tax deductible. Interest paid on life insurance loan is considered personal, and has not been deductible since 1990.
Dividend Taxation
Dividends themselves are not taxable since dividends are considered a return of unearned premium.
In general, interest earned on dividends is taxable as ordinary income in the year earned.
Amounts Received by the Beneficiary
As a general rule, the principal is not considered taxable income, but any earned interest is taxable.
Lump sum death benefits are exempt of any income taxes.
When installment payments via settlement options include principal and interest, the interest is taxed as ordinary income in the year received.
Accelerated Death Benefits
Generally, the payment of an accelerate death benefit is not reportable as taxable income to a recipient if the benefit payment is “qualified.”
A physician gives a prognosis of 24 months or less.
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.
The insurer provides a monthly report for the insured showing the amount paid and the amount of benefit remaining in the life insurance policy. Also known as living benefit, it is not a disability income benefit.
Values Included in Insured’s Estate
Life Insurance proceeds are included as part of the insured’s taxable estate when:
Insured has any incidence of ownership at time of death.
The proceeds are payable to the insured’s estate.
The transferred ownership or gifting occurred within 3 years of death.
Taxation of Personal Life Insurance
Tax-Deductible to alimony payor
Tax-Assessable to the receiver.
Charitable contributions - a Charity is payor and beneficiary, this is deductible as charity.
Death Benefits are generally tax free with some exceptions, such as in Viatical Settlements. The profit is subject to income tax. Cash Value taxable exceeding cost basis. Losses are not tax deductible. Group insurance deductible to employer. Death Benefit is tax free to beneficiary. No cash value in Life Insurance.
Irrevocable Beneficiary dies before insured
Cash value only is included in beneficiary’s estate for federal estate taxes.
Charitable Gifts of Life Insurance Advantages
The donor may remain anonymous if so desired.
The receiving charity’s future value of the life insurance policy is the death benefit. The entire amount is guaranteed even if the insured dies after only one premium payment. Very little documentation is required for the IRS.
Charitable Gift Disadvantages
May be an insurable interest concern in some states. Death benefit might in some cases become part of the decedent’s estate.
Modified Endowment Contracts (MECs)
The 7 Pay Test - you may put in 1/7 in a single year. As long as it’s not exceeded, there’s no problem. Cumulative Sealing, once you own this title, you lose some of the tax advantages.
10% Early Penalty before the age of 59 1/2. Contracts prior to June 20, 1988 are grandfathered in.
TAMRA
After June 20, 1988 all life insurance contracts that do not pass the 7 Pay Test are identified as Modified Endowment Contracts (MECs) and, therefore, lose many of their tax advantages. If a Contract is deemed MEC, any funds distributed are considered Last In, First out rather than FIFO..
Funds distributed are also subject to the 10% penalty on any taxable gains when withdrawn before age 59 1/2.
Taxable distributions include partial withdrawals, cash value surrenders, and policy loans (including automatic premium loans).
7 Pay Test
If the face amount is increased by a material change, his requires a new 7 Pay Test even after June 20, 1988. Increases by a paid up addition, or a cost of living rider are not considered material changes.
Excess Distributions Exempt from 10% Penalty
Distributions made on or after the taxpayer reaches 59 1/2.
Distributions attributable to the death or total disability of the recipient.
Part of a series of equal periodic payments (at least annually) made for the life of the taxpayer or the joint lives of the taxpayer and his/her beneficiary by use of settlement options.
Life Insurance Transfer for Value Rule
A life insurance policy may be transferred to another person in exchange for a valuable consideration. The tax-exempt status of the death proceeds is then lost unless the transfer is to a spouse or business partner presently engaged in business with the policyowner. The IRC clearly states the death benefit will be taxed if the policy is transferred. The law prevents a firm from purchasing tax-exempt life proceeds and evading taxation.
If the policy is gifted, the proceeds will remain tax exempt unless the gifting policy-owner acquired the policy by a transfer for value.
1035 Tax Free Exchange
Internal Revenue Code 1035 - provides that no gain or loss will be recognized on certain exchanges of contracts relating to the same insured:
When one life insurance policy is exchanged for another life insurance policy or an annuity contract (Whole Life for a Universal Life).
When one endowment is exchange for another endowment that provides for payments on or before the original endowment date. Endowments can be exchanged for annuities, but not for life insurance.
Internal Revenue Code 35
A 1035 exchange is actually the assignment by the original insurer to the replacing insurer. Allows for tax-deferred status of invested funds.
Taxation of Annuities
Accumulation and Annuity Phases
Distributions at Death
The Deceased’s Estate
Accumulation and Annuity Phases
Exclusion Ratio - interest earned during the accumulation period is not taxable until annuitization begins and the annuitant starts receiving benefits. Upon receipt of benefits, an annuitant is taxed on the amount of earned interest, not principal. Percentage of principal to interest is the exclusion ratio.
If an annuity is surrendered, any amount received over the cost basis must be reported and is taxed as ordinary income.When annuitant begins receiving distribution payments of principal and interest, the taxation of these payments depends upon the type of annuity option selected for distribution.
Distribution at Death
If the decedent’s annuity payments ceased upon death, nothing is included in the gross estate. If the annuity payments are to continue to another person upon an annuitant’s death, the survivor’s proceeds are included in the gross estate. When a lump sum is paid to a beneficiary during either phase of an annuity, that portion of benefit that exceeds the total contributions of the owner must be reported as income to the IRS.
The Deceased’s Estate
The value of an annuity or other payments received under an individual’s retirement account (IRA) by a beneficiary are to be included in the decedent’s gross estate.
Non-Tax Qualified Deferred Compensation Plans
A Non-Tax Qualified deferred compensation plan is any employer provided retirement plan that does not comply with ERISA.
Most commonly used when an employer wants to select certain key employees for which to provide a retirement plan.
The employer is not entitled to deduct contributions to the plan until the year in which a covered employee receives income from the plan. the employer’s cost basis is equal to premiums paid.
Earnings in the plan are tax deferred to the employee until he/she receives income from the plan.
Funding Issues
Defined Benefit Plan
Defined Contribution Plan
Tax Reform Act of 1986
Pension Protection Act of 2006
Defined Benefit Plan
A qualified pension plan that guarantees a specified level benefit at retirement. A defined benefit plan must pass a minimum participation test:The lesser of 50 employees or 40% of all the employees of that employer.
Tax Reform Act of 1986
States that no more than $200,000 of compensation shall be used to calculate either a Defined Benefit or Contribution Retirement Plan
Pension Protection Act of 2006
This law was enacted because many pension plan funds had become severely underfunded. It gave businesses 2 years to make their pension plan assets meet specified requirements. As of 2008, pension plans must be fully funded. Assets must equal or exceed liabilities.
ERISA
Employee Retirement Income Security Act 1974
Determine eligibility and apply nondiscrimination requirements regarding age and sex.
Normal retirement age is essential in estimating costs.
Benefit formula is commonly 50-70% of the employees’ average compensation in the 5 to 10 years immediately before retirement.
Maximum benefits are required in plans when benefits for key employees might be greater than for other employees.
Supplemental benefits are those such as death, disability, and other authorized withdrawals of benefits during the pre-retirement period.
Employee contributions must be determined to be contributory or noncontributory.
ERISA Cont.
Vesting allows the employee to be able to withdraw all contributions plus interest if he/she discontinues employment. The longer an employee stays with the company, the greater the percentage of funds “vested.”
Alienation of Benefits
The plan may not distribute, segregate, or otherwise attach any portion of participants’ benefits in favor of the participant’s spouse, or former spouse, unless it is mandated by a qualified domestic relations order.
Trustee of Retirement Fund
must ignore any claims of indebtedness received on behalf of an employee unless it is from the IRS in relation to delinquent taxes, then the claim must be honored.
Top Heavy Plan
A plan is considered Top-Heavy plan when the accrued benefits of certain officers, owners, key employees, and the beneficiaries exceeds 60% of the total accrued value of the plan. A top Heavy Plan must be adjusted to comply with the IRS.
ERISA Fiduciary, Reporting and Disclosure Requirements
Department of Labor had determined that a plan administrator automatically has the fiduciary responsibility for the plan. An insurer, third party administrator or an employer may be assigned as plan administrator, but the agent soliciting th eplan and earning commissions cannot be.
Administrator Requirements
Administrator is responsible for filing all reports and disclosures with the Department of Labor. Following are the 5 required reports: Summary Plan Description Annual Reports Notice of Material Modifications Terminal Report Notice of Amendments
Summary Plan Description
Must contain the name of the plan address, employer’s tax identification number, the plan’s fiscal year dates, the names of the plan administrator and his/her business phone number.
Annual Reports
Must be filed by the last day of the 7th month following the end of each fiscal year of the plan.
Notice of Material Modifications
Must be completed within 30 days of receiving a Department of Labor request for this report. A $10 per day fine will be assessed for each day the report is late up to $1000.
Terminal Report
The Administrator of any terminating defined benefit plan must file a termination report with the Secretary of Labor and the Pension Benefit Guaranty Corporation
Notice of Amendments
Plan amendments which reduce accrued benefits of a participant may not take effect unless the administrator has filed a notice of amendment with the department of labor.
Vesting Schedule
Benefits from the employer’s contributions will be vested by 0% for the first 2 years, then 20% each year thereafter until the 7th year when the employee is 100% vested.
Qualified Retirement Plans
These plans must meet certain qualifications set by Congress that allows them to have certain tax advantages. Established for the exclusive benefit of a firm’s employees, the plan must be formed by written agreement and cannot discriminate in favor of any highly compensated employee(s). Removing money from any of these retirement plans would result in an IRS penalty tax if the withdrawal is not a rollover or the action is taken before the person is 59 1/2.
Qualified Retirement Plan Benefits are:
Employer contributions are a tax deductible business expense to the employer.
Interest and earnings accumulate tax deferred.
Employer contributions are taxable to the employee when received.
Qualified Retirement Plans Include:
SIMPLE SEP HR-10 Plans Profit-Sharing and 401(k) Plans ESOP Section 457 Deferred Compensation 403(b) Tax-Sheltered Annuities (TSA) IRAs Pension Plans
Savings Incentive Match Plan for Employees
S.I.M.P.L.E
Must be the only type of retirement plan the firm has available for the employees, except a Deferred Compensation 457 Plan.
May be written as an IRA or a 401(k)
Organization must have no more than 100 employees, earning at least $5,000 annually.
Payroll deductions are expressed as a percentage of compensation and may not exceed $10,000 annually indexed for inflation.
SIMPLE Cont.
Employer must match up to 3% of the employee elective contributions or contribute 2% of nonelective contributions in behalf of each group member.
Vesting is 100% immediately, with a 25% penalty for premature withdrawals the first 2 years.
Employees who are 70 1/2 or older may participate.
Neither the SIMPLE IRA or 401(k) require the participant to meed the ADP Test, Actual deferred percentage.
Maximum contributions are indexed for inflation. Advantage is lower administrative costs.
Simplified Employee Pensions
SEPs
Employer may contribute to employee’s IRA and deduct it as a business expense.
These contributions are taxable as income to the employee upon receipt at retirement.
Annuities are commonly the funding medium used.
Self Employed Plans (HR-10)
Self-Employed individuals may contribute part of his/her earned income into a retirement plan and deduct those contributions from present taxable income.
Any self employed individual having employees who meet certain qualifications must also contribute to a retirement plan for those employees.
Profit Sharing and 401(K)
401(K) Plans are profit-sharing plans allowing an employee a choice between taking income in cash or putting the income into a qualified plan and deferring that portion of income.
Rollover transfers between qualified plans on a trustee-to-trustee basis will avoid mandatory income tax withholding. If the transfer is trustee-to-employee to trustee, a 20% tax must be paid and only 80% is the rollover amount, with income taxes due on the full amount.
Employee Stock Ownership Plan (ESOP)
A qualified defined contribution plan with benefits distributed in the form of employer stock.
Section 457 Deferred Compensation
Employees of states, counties, and municipalities may set up an arrangement where the employer agrees with each employee to reduce his/her pay by a specified amount and to invest the deferred in one or more investments for the employee’s retirement.
These amounts will be distributed to the employee, upon death, retirement, or termination.
Deferred annuities are a popular investment for these types of plans.
403(b) Tax-Sheltered Annuities (TSAs)
Employees of nonprofit organizations IRC SEC 501(c) and public schools IRC SEC 403(b) may have an arrangement whereby the employer agrees with each participating employee to reduce his/her pay by a specified amount and invest it ins a retirement fund or contract for the employee. Employees do not make direct payments to retirement fund.
These accounts are owned by the employee, and are non-forfeitable and will be paid upon death, retirement, or termination of the employee.
All monies invested and the interest accumulations are tax-deferred until received.
IRAs
Anyone under the age of 70% who has earned income may open an IRA. Contributions grow tax-free until withdrawn. Maximum contribution limits imposed by the IRS.
Payments must start by age 70 1/2 or incur a 50% excise tax.
IRA Rollovers
TSA and qualified retirement plans are subject to 20% withholding tax.
You cannot rollover an individual or Roth IRA into a 401(k). IRAs may be funded using mutual funds, common stock or CDs, or annuities, but not life insurance.
Early withdrawal without penalties for:
Long Term Disability
Qualified first time home buyer
Medical expenses are excessive and without prognosis of recovery.
Pension Plans
A retirement account that is set up by an employer for its employees.
the plans must be funded, meaning the benefits are payable out of funds, (insurance or annuities) specifically set aside in advance.
All qualified pension plans must have an establishing vesting schedule.
IRS requirements of Tax Qualified Plans
There must be a minimum level of participation and vesting stated in the contract.
All benefits remain equal or improve upon any merger of 2 or more plans.
When a participant may begin receiving distribution from the plan must be stated in the contract.
Limitations of benefits both minimums and maximums must be stated at the beginning of a contract. Benefits may not be reduced by any social security retirement benefit. Must provide either a joint and survivor or survivor benefit for the participant and his/her beneficiary. Procedures for claims review must be available both to the participant and his/her beneficiary.
Special Rules (qualified)
Incidental limitation is the maximum amount of life insurance that may be purchased by a qualified plan on the life of a plan participant.
A qualified plan must exist primarily for the purpose of providing a retirement benefit, any life insurance int he plan must be incidental.
Qualified Plans
Contributions are tax-deductibles except Roth IRAs. Permanent, and in writing, and communicated, and must be vested to a certain schedule. Alienation of Benefits - marriage, spouse must always be beneficiary, and cannot be directed to another.
Defined Benefit
Specified specific amount, to guarantee that particular benefit. 25% of his last 5 years. If pension trustee earns less, employer must contribute difference. Ensure it’s properly funded, places risk on employer
Defined contribution
Percentage of income, employer defines how much they will put into a trust. Employer makes no guarantee, only what is deposited. Money Purchase Plans
TSA/TDA
teachers, non profit organizations.
Deferred Compensation Plan
Immediately vested, common 401(k) section 457, and TSA. Made with employee deposits, and voluntary employer match. Required for all workers.
Costs of Life Insurance on Qualified and Profit Sharing Plans
Some retirement plans have a fringe benefit of life insurance. The purpose of this coverage is to provide dependents with an amount calculated to equal a future gross retirement benefit should be covered employee die prematurely.
Some responsibilities and characteristics
If premium for this life insurance is paid on a noncontributory basis, the premium is taxable as income to the employee for the year in which premiums were paid.
When the plan is insured by a term policy, the full amount of premium is reported as income.
The IRS uses a rate table for the insurance plans that are other than term insurance. The rating tables are referred to as P.S. 58 Tables.
P.S. 58 Tables
When the amount of employer contribution is known, the table reflects the portion of the contribution that would normally be paid in insurance premium.
Once the premium is calculated by using the P.S. 58 Tables, that amount is reported on the employee’s W-2 form and is taxed as ordinary income.
Tax Payers Relief Act of 1997
Roth IRA - established in 1997. Developed for single people with income levels below $95,000 and married couples below $150,000. Singles with incomes between $95,000 - $110,000 and couples with $150,000-$160,000 may make a reduced contribution.
Distribution of Proceeds
For qualified first time home-buyers $10,000 maximum. Qualified tuition for higher education. This is presently without limitations when paying only the tuition charges on an annual basis.
