Chapter 7 Federal Tax Considerations and Retirement Plans Flashcards
premiums
premiums are considered a personal expense and are not deductible. they are paid with after tax dollars. this establishes a cost basis in the policy for tax purposes
Cash values
A cash value policy will generally experience increases in the cash value annually. part is from the premium and part is from any interest or gains. The interest or gains are not taxable at the time they are credit to the policy.
In general an earnings in the cash value are allowed to grow on a tax deferred basis until one of the following events occurs.
The policy is surrendered
The policy is transferred for value (sold or assigned)
The policy ceases to meet the irs definition of a life insurance contract.
If the policy owner does sell, surrender, or withdraw funds from the policy, the difference between what is received and what has been paid in is generally taxed as ordinary income. This is the Cost Recovery Rule.
When withdrawing cash from a cash value life insurance policy, the amount of withdrawals up to the
policy’s basis will be tax free. This is referred to as first in , first out, or fifo. basis is the amount of premiums paid into the policy less any dividends or withdrawals previously taken. any withdrawals in excess of basis will be taxed as ordinary income
upon surrendering a cash value life insurance policy, any gain on the policy will be
subjected to federal and possible state, income tax. The gain on the surrender of a cash value policy is the difference between the gross cash value paid out, plus any loans outstanding, and the basis of the policy. When the policy matures, it can be paid in a limp sum or using one of the settlement options. As with other distributions made, the sum in excess of the cost basis is taxable ordinary income. If the cash value is more than the premium that is taxable
Policy Loans
If a policyowner takes out a loan against the cash value of a life insurance policy, the amount of the loan is not taxable. This is true even if the loan is larger than the amount of the premiums paid in. If the policy lapses with a loan outstanding, the excess over cost basis becomes taxable as ordinary income.
Dividends
are not taxable since dividends are considered a return of unearned premium. interest earned on dividends are taxable.
Death benefit proceeds (claims)
not taxable (principle) Interest(taxable when received in installments).
Estate taxes and benefits included
These values will be added to the amount in the estate and potentially be subject to federal estate taxes. If the policyowner is also the named insured, the proceeds will be added to the value of the insured estates.It is usually recommended to name an owner other than the insured for this reason.
Accelerated Death benefits
is tax free to a recipient if the benefit payment is qualified,
To be qualified benefit the benefit must meet the following criteria
a physician must give a prognosis of 24 months or less life expectancy for the named insured.
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 provided a monthly report for the insured showing the amount paid and the amount of benefit remaining in the life insurance policy
Taxation of group life insurance
Premiums paid by the Employer and the Employee
Group term life premiums paid by an employer are tax deductible to the business as an ordinary and necessary business expense. Any employee paid premiums are not eligible for tax deduction. Employer paid premiums in connection with group life does constitute taxable income to the employee unless the death benefit paid for by the employer exceeds 50,000. All employer paid premiums for amounts above 50,000 are reported as taxable income to the employee
Death benefit proceeds
from a group life insurance plan to an employee’s named beneficiary are received income tax free.
Modified Endowment contracts (MECs)
MEC rules impose stiff penalties to eliminate the use of life insurance as a short term saving vehicle. If a policy is funded too quickly it will be classified as a modified endowment contract. Prevents wealthy from dumping large amounts of money into a cash value policy, tax deferred.
7-pay test
When a contract does not pass the 7 pay test, it is a MEC. its a limitation on the total amount that can be paid into a policy in the first 7 years. It compares premiums paid for the policy during the first 7 years with the net level premiums that would have been paid on a 7 year pay whole life policy providing the same death benefit. As long as the policy premium guidelines are met, the policy will avoid being deemed a modified endowment contract.
If a policyowner manages to pay premiums in excess of the guidelines, the excess premiums can be
refunded by the insurer within 60 days after the end of the contract year. Since a single premium life insurance policy clearly does not pass the 7-pay test, it will automatically be deemed a MEC.
The other types of polices that could be classified as MEC’s are
flexible premium policies such as universal and variable universal life. The flexible premium feature allows the owner to pay premiums on their own schedule. One classified as a MEC, it will maintain that classification for the life of the policy. The overfunding cannot be undone in future years.
Taxation for MEC
if a contract is deemed to be a MEC, than any funds that are distributed are subject to LIFO tax treatment rather than a normal FIFO tax treatment. Taxable distributions include partial withdrawals, cash value surrenders and policy loans (including automatic premium loans)
Penalties for MEC
If contract is MEC all cash value transaction are subject to taxation and penalty. Funds are subject a 10% penalty on gains withdrawn prior to age 59.5. This is considered a premature distribution. Distributions made on or after 59.5 and distributions paid out due to death or disability are not subject to the penalty.
Life insurance transfer for value rule
If policyowner is transfered and transfer of policy of ownership does not qualify for exception, the death benefit becomes taxable. the policy sold amount + premium amounts are tax free. Death benefit - that is taxable
section 1035 exchange
applies to nonqualifed contracts only. exchange of existing insurance policies into another without incurring any tax liability on the interest and/or investment gains. These tax-free exchanges are useful if another insurance policy has features and benefits that are preferred or are superior to those found in an existing contract.
Surrender charges might still apply on the existing contract and a new surrender charge period may commence after exchange on the newly acquired policy. The new insurance contract may have higher fees and charges than the old one, which will inevitably reduce the returns or involved an increase in costs for such things as policy loans.
Types of exchanges the IRS will allow on a tax-free basis are
Life insurance to life insurance Life insurance to an annuity annuity to an annuity Life insurance or annuity to long-term care NEVER an annuity to life insurance
1035 The new life policy will be issued on after
a new app for coverage is received and the policy is issued.
Individual annuities taxation
Tax qualified annuities are generally funded with pre-tax dollars. They’re also fully taxable at ordinary income rates when money is withdrawn because the premiums paid and subsequent premiums do not establish a cost basis. Non-qualified annuities are generally funded with after tax dollars. The premiums paid for the non-qualified establish the cost basis. The cost basis equals the total amount paid for a deferred annuity. The basis is the starting point for establishing gain or loss. Any interest or other gains during the accumulation phase of the annuity are tax deferred. If the policy is cashed out, then any amount received in excess of the cost basis is taxable as ordinary income.
Spouse at your tax rate, beneficiary their tax rate
