Chapter 7

Question 1

Taxation of Personal Life Insurance

Answer 1

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.

Question 2

Cost Recovery Rule

Answer 2

The cash value minus the sum of premiums paid equals equity. Owner is taxed on the contract equity for cash values.

Question 3

Policy Loan Taxation

Answer 3

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.

Question 4

Dividend Taxation

Answer 4

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.

Question 5

Amounts Received by the Beneficiary

Answer 5

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.

Question 6

Accelerated Death Benefits

Answer 6

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.

Question 7

Values Included in Insured’s Estate

Answer 7

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.

Question 8

Taxation of Personal Life Insurance

Answer 8

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.

Question 9

Irrevocable Beneficiary dies before insured

Answer 9

Cash value only is included in beneficiary’s estate for federal estate taxes.

Question 10

Charitable Gifts of Life Insurance Advantages

Answer 10

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.

Question 11

Charitable Gift Disadvantages

Answer 11

May be an insurable interest concern in some states. Death benefit might in some cases become part of the decedent’s estate.

Question 12

Modified Endowment Contracts (MECs)

Answer 12

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.

Question 13

TAMRA

Answer 13

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).

Question 14

7 Pay Test

Answer 14

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.

Question 15

Excess Distributions Exempt from 10% Penalty

Answer 15

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.

Question 16

Life Insurance Transfer for Value Rule

Answer 16

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.

Question 17

1035 Tax Free Exchange

Answer 17

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.

Question 18

Internal Revenue Code 35

Answer 18

A 1035 exchange is actually the assignment by the original insurer to the replacing insurer. Allows for tax-deferred status of invested funds.

Question 19

Taxation of Annuities

Answer 19

Accumulation and Annuity Phases
Distributions at Death
The Deceased’s Estate

Question 20

Accumulation and Annuity Phases

Answer 20

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.

Question 21

Distribution at Death

Answer 21

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.

Question 22

The Deceased’s Estate

Answer 22

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.

Question 23

Non-Tax Qualified Deferred Compensation Plans

Answer 23

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.

Question 24

Funding Issues

Answer 24

Defined Benefit Plan
Defined Contribution Plan
Tax Reform Act of 1986
Pension Protection Act of 2006

Question 25

Defined Benefit Plan

Answer 25

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.

Question 26

Tax Reform Act of 1986

Answer 26

States that no more than $200,000 of compensation shall be used to calculate either a Defined Benefit or Contribution Retirement Plan

Question 27

Pension Protection Act of 2006

Answer 27

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.

Question 28

ERISA

Answer 28

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.

Question 29

ERISA Cont.

Answer 29

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.”

Question 30

Alienation of Benefits

Answer 30

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.

Question 31

Trustee of Retirement Fund

Answer 31

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.

Question 32

Top Heavy Plan

Answer 32

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.

Question 33

ERISA Fiduciary, Reporting and Disclosure Requirements

Answer 33

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.

Question 34

Administrator Requirements

Answer 34

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

Question 35

Summary Plan Description

Answer 35

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.

Question 36

Annual Reports

Answer 36

Must be filed by the last day of the 7th month following the end of each fiscal year of the plan.

Question 37

Notice of Material Modifications

Answer 37

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.

Question 38

Terminal Report

Answer 38

The Administrator of any terminating defined benefit plan must file a termination report with the Secretary of Labor and the Pension Benefit Guaranty Corporation

Question 39

Notice of Amendments

Answer 39

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.

Question 40

Vesting Schedule

Answer 40

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.

Question 41

Qualified Retirement Plans

Answer 41

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.

Question 42

Qualified Retirement Plan Benefits are:

Answer 42

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.

Question 43

Qualified Retirement Plans Include:

Answer 43

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

Question 44

Savings Incentive Match Plan for Employees

Answer 44

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.

Question 45

SIMPLE Cont.

Answer 45

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.

Question 46

Simplified Employee Pensions

Answer 46

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.

Question 47

Self Employed Plans (HR-10)

Answer 47

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.

Question 48

Profit Sharing and 401(K)

Answer 48

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.

Question 49

Employee Stock Ownership Plan (ESOP)

Answer 49

A qualified defined contribution plan with benefits distributed in the form of employer stock.

Question 50

Section 457 Deferred Compensation

Answer 50

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.

Question 51

403(b) Tax-Sheltered Annuities (TSAs)

Answer 51

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.

Question 52

IRAs

Answer 52

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.

Question 53

IRA Rollovers

Answer 53

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.

Question 54

Pension Plans

Answer 54

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.

Question 55

IRS requirements of Tax Qualified Plans

Answer 55

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.

Question 56

Special Rules (qualified)

Answer 56

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.

Question 57

Qualified Plans

Answer 57

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.

Question 58

Defined Benefit

Answer 58

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

Question 59

Defined contribution

Answer 59

Percentage of income, employer defines how much they will put into a trust. Employer makes no guarantee, only what is deposited. Money Purchase Plans

Question 60

TSA/TDA

Answer 60

teachers, non profit organizations.

Question 61

Deferred Compensation Plan

Answer 61

Immediately vested, common 401(k) section 457, and TSA. Made with employee deposits, and voluntary employer match. Required for all workers.

Question 62

Costs of Life Insurance on Qualified and Profit Sharing Plans

Answer 62

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.

Question 63

Some responsibilities and characteristics

Answer 63

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.

Question 64

P.S. 58 Tables

Answer 64

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.

Question 65

Tax Payers Relief Act of 1997

Answer 65

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.

Question 66

Distribution of Proceeds

Answer 66

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.