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
Exclusion ratio
taxation of annuities is computed is referred to as the exclusion ratio. The IRS has tables and formulas to determine which part of the income benefit payment is tax-free return of premium and which part is taxable. After the entire cost basis is recovered then any future income benefit payments received are fully taxable.
Investments are taxed LIFO, that means for income tax the first money out of the annuity will be considered earnings, not principal and will be taxed. Withdrawals made prior to the annuitant’s age 59.5 are subject to a 10% early withdrawal penalty.
The expected return is affected by the settlement option chosen and is based on the total amount the annuitant can expect to receive under the contract.
For variable annuity, income payments determining the amount of each payment that is tax free is by dividing the investment in the contract by the total number of periodic payments expected to be received based on the settlement option selected under the contract.
Distributions at death
When the annuitant dies during the accumulation phase of the annuity the beneficiary receiving the death benefit must pay income tax on any gain embedded in the policy at ordinary income tax rates.
Estate taxation
During the accumulation phase, if the contract owner dies, the value of the annuity is included in the owner’s estate value. If the annuitant dies during the annuity or payout phase, the remaining value in the account will be added to the deceased annuitant’s estate for valuation. However, if the annuitant was receiving income from a pure life or straight life annuity, the company keeps the balance and nothing goes into estate.
corporate owned annuities
An annuity contract owned by a non-natural person is not treated as an annuity for federal income tax purposes so the contract’s gains are currently taxed as opposed to being tax deferred. There are no tax benefits when an annuity is owned by a corporation.
Federal tax considerations for retirement plans
qualified plans must meed the requirements of
ERISA, which is a federal law that sets minimum standards for pension plans in private industry. It does not require an established pension plan but if there is a plan they must meet these standards:
Must benefit employees and beneficiaries
May not discriminate in favor of highly compensated employees
Must be approved by the IRS
Have a vesting requirement
qualified plans receive
favorable tax treatment. Employer contributions are immediately tax deductible to the employer at the time the contribution is made. These contributions are not taxable to the employee until withdrawn. Employee contributions are pretax or tax deductible. Distributions taken prior to age 59.5 are subject to taxation and a 10% penalty. retirees must begin taking taxable distributions at age 70.5
Nonqualfied plans do meet requirement of federal to be
eligible for favorable tax treatment. Because of this, contributions to a nonqualified plan are not tax deductible. In many cases such as a nonqualfied annuity, the earnings are still tax deferred until withdrawn. Upon withdrawal, only the earnings are taxable.
Individual Retirement Accounts (IRAs)
They are established by individuals so they are not qualified plans. an individual can set up a traditional or roth IRA, whether or not their employer has established a qualified plan at work
Traditional IRAS
Anyone under the age of 70.5 who has earned income may open an IRA. Contributions may be tax deductible in whole or part. A nonworking spouse can also set up a spousal IRA based on the working spouse’s income. Contributions grow tax-deferred until thy are withdrawn. There is a maximum annual contribution allowed by the IRS, as well as a “catch up” contribution for persons age 50 and older. All amounts are contributed pretax plus gains withdrawn from an IRA are fully taxable as ordinary income.
IRAS distributions
Withdrawals known as RMDs, from the account must start by April 1 of the year following the year the owner turns age 70.5. Failure to take all or part of an annual RMD incurs a 50 % penalty tax on the amount not distributed.
Withdrawals before age 59.5 are subject to a 10% penalty tax
can be taken out early without penalty for:
death or permanent disability
Down payment of a home for first time home buyers
medical expenses not covered by health insurance
college
IRAs may be funded using
mutual funds, common stock, certificates of deposit, or annuities; but not life insurance. Life insurance does not meet the IRS qualifications of an IRA.
Roth IRA
nondeductible tax free retirement plan for anyone with earned income. Max annual contribution limits apply as set froth by the IRS plus a catch up contribution.
Unlike a traditional IRA, contributions are not tax deductible. However, as long as the account has been open for at least 5 years and the owner is at least 59.5 proceeds may be received tax free. Taxpayers can also take a tax free and penalty free distribution of earning in cases of death, disability, first time home purchase.
non-qualfied distribution is subject to taxation of earnings and a 10% additional tax unless an exception applies If a person owns a traditional IRA and a Roth IRA, the combined contributions to both cannot exceed the annual max IRA contribution for one IRA.
Rollovers and Transfers of IRAs
The IRS permits an IRA rollover from one account to another or a transfer. this may avoid
taxation as an early withdrawal.
IRAs rollover
The payment is made directly to the IRA owner. The owner will have 60 days to deposit the check into a new IRA to avoid taxes and penalties. This type of transaction is reported to the IRS and is only allowed once per year. A 20% withholdings of funds is required unless a direct rollover occurs. A direct rollover applies when the funds are transferred from one qualified plan to the trustee of an IRA or another plan. There is no 60 day requirement. Spouse pays 0% tax, nonspouse pays 100% tax if rollover
IRA transfer
IRA assets can be transferred directly into a new account. An IRA transfer is the movement of funds between the same type of plan, such as two IRA accounts. The money is transferred directly from one financial institution to another. Transfers are not taxable and can take place as often as desired.
Qualified retirement plan types, characteristics and purchasers
There are two broad categories of qualified retirement plans: defined benefit plan and defined contribution plan
defined benefit plan
provides employees with a fixed and known benefit at retirement, the amount of which generally depends upon length of service and highest attained salary. The company assumes the responsibility for making sure money will be availbe to fund a pension for retiring workers
defined contribution plan
provides employees with a retirement benefit based on the value of the employees account at retirement. The employer and employee or both can make contributions. This is a type of retirement plan in which a certain amount or % of money is set aside each year by a company for the benefit of the employee.
characteristics of some qualified plans are:
Savings incentive match plan for employees (SIMPLE)
Simple plan may be established either as an IRA or a 401k plan. The employers contribution must be immediately vested at 100%. This means that the employee is entitled to all the employers’ contributions immediately. companies have 100 employees or less and must be the only type of plan the company has available for the employees. advantage elimination of high administrative costs
Simplified employee pensions (SEP)
SEP are set up by any private sector company that does not offer another type of qualified plan. This plan is very popular with self employed individuals. The SEP plan uses employer funded IRA’s. The employer makes contributions and deducts as a business expense. All distributions are taxable upon receipt.
Self-employed plans (HR-10 or KEOGH Plans)
KEOGH Plans or HR-10 plans are available to unincorporated sole proprietors and their eligible employees. Silent partners are not eligible. Contributions for eligible employees are mandatory and based on the % of contribution made by the employer for his or her own account. These contributions are deductible.
Today they’ve been largely replaced by SEP IRA’s which have the same contribution limits but much less paperwork.
Profit sharing and 401K plans
Private companies. contribution plan for the employees of for-profit companies. It is an elective deferral plan or salary reduction. 401K plans also an be 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.
If the employees elect a defined contribution plan
employees define their contribution amount as a % of income or a fixed dollar amount per payroll period and the employer must deduct that amount from pay and forward to the plan custodian on a timely basis. Participants typically invest in a portfolio of mutual funds. Employers may contribute and match funds to participant accounts as long as the contribution formula is not discriminatory
If the plan is incorporated as a profit sharing plan
The employer defines the circumstances under which profit-based contributions will be made, and contributions must generally be mad in at least 3 out of 5 consecutive years.
Tax-sheltered annuties
TSA are qualified annuity plans benefitting employees of public schools under 403B, as well as other nonprofit organizations qualified by the internal revenue code. Employees of non profit organizations may have an arrangement with the employers whereby the employer agrees with each participating employee to reduce the employee’s pay by a specified amount and invest in a retirement fund or contract for the employee. Employees do not make direct payments to the retirement fund. These accounts are owned by the employee and are nonforfeitable and will be paid upon death, retirement, or termination of the employee. Contributions are pre-tax and interest earned grows tax deferred
