Chapter 7: Federal Tax Considerations and Retirement Plans

Question 1

Premiums

Answer 1

For INDIVIDUALS, 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.

Question 2

Cash Values

Answer 2

A cash value policy will 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 credited to the policy.

Any earnings in the cash value are allowed to grow on a tax-deferred basis until one of the following events occurs:

• Policy is surrendered
• Policy is transferred for value (e.g., sold or assigned)
• Policy ceases to meet the IRS definition of a life insurance contract

Question 3

Cost Recovery Rule (Pertaining to Taxation of Cash Values)

Answer 3

If the policyowner does sell, surrender, or withdraw funds from the policy, the difference between what is received and what had been paid in IS TAXED as ordinary income.

Question 4

First In, First Out (FIFO)

Answer 4

Amount of withdrawals from a cash value policy up to the policy’s basis will be TAX FREE

Question 5

Cost Basis

Answer 5

The amount of premiums paid into the policy less any dividends or withdrawals previously taken. Any withdrawals in excess of the cost basis are TAXED as ordinary income.

Question 6

Surrendering a Cash Value Life Insurance Policy

Answer 6

Any gains are subject to federal and possibly 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 cost basis in the policy. When the policy matures (endows), cash can be paid in a lump sum or by using one of the settlement options offered by the insurer. As with other distributions made while the insured is alive, the sum in excess of the cost basis is TAXABLE as ordinary income.

Question 7

Policy Loans

Answer 7

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. The loan is NOT TAXED as long as the policy is in force.

If the policy lapses with a loan outstanding, the excess over cost basis becomes TAXABLE as ordinary income.

The interest paid on a permanent life insurance policy loan is NOT TAX-DEDUCTIBLE.

Question 8

Dividends

Answer 8

A participating insurance company’s dividend consists of the amount of premium that is returned to the policyowner if the insurance company achieves lower mortality and expense costs than expected. Dividends are paid out of the insurer’s surplus earnings for that year.

The dividends themselves are NOT TAXABLE since dividends are considered a return of unearned premium.

When dividends:

• Are left on deposit with the insurance company, interest earned on the dividends IS TAXABLE as ordinary income in the year earned
• Received to exceed the total premium paid for the life insurance policy, the excess dividends are then considered TAXABLE income.

Question 9

Death Benefit Proceeds (Claims)

Answer 9

• Paid as a lump sum to beneficiary - NOT TAXABLE as income
• If settlement option is used (instead of a lump sum) - any interest or earnings component of each payment IS TAXABLE as ordinary income

Question 10

Estate Taxes and Benefits Included

Answer 10

Benefits may be included in the insured’s estate, either intentionally or by default. The policyowner may name the estate as a beneficiary, or by default, if no beneficiary is living at the time of the insured’s death, the benefit will automatically be paid into the insured’s estate. 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’s estate. It is usually recommended to name an owner other than the insured for this reason.

Question 11

Accelerated Death Benefits

Answer 11

The payment of an accelerated death benefit is tax free to a recipient if the benefit payment is qualified. To be a qualified benefit, it must meet the following conditions:

• A physician must give a prognosis to the named insured of a life expectancy 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.

Question 12

Premiums paid by the EMPLOYER (Group Life Insurance)

Answer 12

Group Term Life premiums paid by an employer ARE TAX DEDUCTIBLE to the business as an ordinary and necessary business expense.

Premiums paid by the employer in connection with group life insurance DO NOT 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.

Question 13

Premiums paid by the EMPLOYEE (Group Life Insurance)

Answer 13

Any employee paid premiums are NOT TAX DEDUCTIBLE.

Question 14

Death Benefit Proceeds

Answer 14

Death benefit proceeds from a group life insurance plan to an employee’s named beneficiary are received income TAX FREE

Question 15

Modified Endowment Contracts (MECs)

Answer 15

Under current law, if a policy is funded too quickly, it is classified as a Modified Endowment Contract or a MEC. MEC rules impose stiff penalties to eliminate the use of life insurance as a short term savings vehicle.

Question 16

7-Pay Test

Answer 16

When a contract does not pass the 7-pay test, it is deemed a MEC. The 7-pay test is 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 policy premium guidelines are met, the policy will avoid being deemed a MEC.

If a policyowner pays premiums in excess of the guidelines, the excess 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 is automatically deemed a MEC.

The other types of policies that could be classified as MECs are flexible premium policies such a Universal and Variable Universal Life. The flexible premium feature allows the owner to pay premiums on their own schedule. One a policy is classified as a MEC, it maintains that classification for the life of the policy. The overfunding cannot be undone in future years.

Question 17

Taxation

Answer 17

If a contract is deemed to be a MEC, then any funds that are distributed are subject to a “last-in, first-out” (LIFO) tax treatment, rather than the normal “first-in, first out” tax treatment. Taxable distributions include partial withdrawals, cash value surrenders and policy loans (including automatic premium loans).

Question 18

Penalties

Answer 18

If the contract is a MEC, all cash value transactions are SUBJECT TO TAXATION and penalty. Funds are subject to a 10% penalty on gains withdrawn prior to age 59.5. This is considered a premature distribution. Distributions made on or after age 59.5, and distributions paid out due to death or disability, are NOT subject to penalty.

Question 19

Life Insurance Transfer for Value Rule

Answer 19

This rule was passed by Congress to discourage business transfers of ownership between parties looking to take advantage of the tax-free status of life insurance death benefit.

If a life insurance policy is transferred to a new owner in return for any kind of material consideration, the transfer-for-value rule partially removes the tax-exempt status of a life insurance policy. The rule states that the amount of the death benefit that exceeds the value of consideration and any additional premium paid will be taxed as ordinary income.

If the transfer qualifies as an allowable exception to the rule, the death benefit will be paid tax free.

Question 20

Section 1035 Exchanges

Answer 20

Internal Revenue Code Section 1035 allows for the exchange of an existing insurance policy or contract for another without insuring any tax liability on the interest and/or investment gains in the current contract. The tax-free exchanges, known as 1035 exchanges, can be useful if another insurance policy has features and benefits that are preferred or are superior to those found in an existing contract.

Policyowners must be aware that surrender charges might still apply on the existing contract, and a new surrender charge period may start after the exchange on the newly acquired policy. Further, the new insurance contract may have higher fees and charges than the old one, which will reduce or increase costs for such things as policy loans.

When moving from an existing life insurance policy to a new life insurance policy as part of the 1035 exchange, the new life insurance policy will be issued only after a new application for coverage is received and the policy is issued and accepted.

Question 21

Types of exchanges the IRS WILL allow on a tax-free basis are from:

Answer 21

• 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!!!

Question 22

Individual Annuities (Taxation)

Answer 22

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. Premiums paid for a non-qualified annuity, along with any subsequent premiums, establishes the cost basis for the non-qualified annuity.

**Cost basis equals the total amount paid for a deferred annuity. The basis is the starting point for establishing gain or loss. An interest or other gains during the accumulation phase of the annuity are TAX-DEFERRED.

Question 23

Lump Sum Cash Out for Individual Annuity (Taxation)

Answer 23

Any amount received in excess of the cost basis is taxable as ordinary income.

Question 24

Individual Policy Annuitized (Taxation)

Answer 24

Original investment is returned in equal TAX-FREE installments over the payment period. These payments are not taxed since they are simply a return of principal, while the balance of monies received in annuity payments IS THE TAXABLE gain or earnings. This is taxed at ordinary income tax rates even if the gains come from the investment separate accounts found within a variable annuity.

Question 25

Exclusion Ratio

Answer 25

The way in which taxation of annuities is computed. The IRS has tables and formulas to determine which part of the income benefit payment is a tax-free return of premium and which part is taxable. After the entire cost basis is recovered, any future income benefit payments received are fully taxable.

Question 26

Distributions at Death

Answer 26

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.

Question 27

Estate Taxation

Answer 27

During the accumulation phase, if the contract owner dies, the value of the annuity is included in the owner’s estate for valuation. If the annuitant dies during the annuity payout phase, the remaining value in the account is added to the deceased annuitant’s estate for valuation.

However, if the annuitant was receiving income from a Pure or Straight Life annuity, the company keeps the balance and nothing goes into the annuitant’s estate for valuation.

Question 28

Corporate-Owned Annuities

Answer 28

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. In short, there are no tax benefits when an annuity is owned by a corporation.

Question 29

Qualified Plans (Federal Tax Considerations for Retirement Plans)

Answer 29

Must meet the requirements of ERISA (Employee Retirement Income Security Act), a federal law that sets minimum standards for pensions plans in private industry. ERISA does not require any employer to establish a pension plan. It only requires that those who establish plans must meet certain minimum standards.

ERISA qualified plans:

• 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 either pretax or tax deductible. Distributions taken prior to 59.5 are subject to taxation with a 10% penalty - penalty may be waived for death, disability, qualified education costs, medical expenses, first time home buyers, and substantial equal payments over life expectancy. Because most qualified plans defer taxes, retirees must begin taking taxable distributions at age 70.5 or they will incur a tax penalty.

Question 30

Nonqualified Plans (Federal Tax Considerations for Retirement Plans)

Answer 30

DO NOT meet requirements of federal law to be eligible for favorable tax treatment. Because of this contributions ate NOT tax deductible. In may cases, such as a nonqualified annuity, the earnings are still tax deferred until withdrawn. Upon withdrawal, only the earnings are taxable.

Question 31

Executive Bonus Plans (Federal Tax Considerations for Retirement Plans)

Answer 31

Considered to be nonqualified plans and is one in which an employer pays the premiums on a permanent life insurance policy owned by an employee. The employer may be able to deduct salary and compensation under Section 62 of the IRC. Since this plan is designated to provide a salary to the employee upon retirement, the premiums, within limits, are tax deductible to the employer, and the income is taxable to the employee when paid out.

These plans are nonqualified because they are designed to discriminate in favor of highly-compensated key employees. While the employer pays the initial premiums, additional funds can be deposited by the employee.

Question 32

Individual Retirement Accounts (IRAs)

Answer 32

Because IRAs are established by individuals, they are not considered “qualified plans”. IRAs are described in Section 408 of the Tax Code and have their own set of rules. This means an individual can set up a traditional Roth IRA, whether or not the employer has established a qualified plan at work.

Question 33

Traditional IRAs

Answer 33

Anyone under the age of 70.5 who has earned income may open an IRA. Contributions may be tax deductible in whole or part, or nondeductible if the owner is a participant in an employer-sponsored retirement plan and gross income exceeds certain thresholds. A non-working souse can also set up a Spousal IRA based on the working spouse’s income. Contributions grow tax-deferred until they 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 contributed pretax, plus gains withdrawn from an IRA, are fully taxable as ordinary income.

Question 34

Distributions from Traditional IRAs

Answer 34

Withdrawals, known as Required Minimum Distributions (RMDs), from the account start by April 1 of the year following the year the owner turns 70.5. Failure to take all or part of an annual RMD incurs a 50% penalty tax on the amount not distributed.

Question 35

Premature Distributions from Traditional IRAs

Answer 35

Withdrawals before 59.5 are generally subject to a 10% penalty tax.

Once funded, permissible investments in an IRA may include mutual funds, common stock, certificates of deposit, or annuities to name a few. Life insurance is NOT a permissible investment in an IRA.

An IRA account owner may take an early withdrawal without penalty tax when certain qualified events occur, such as:

• Death or permanent disability
• Up to $10,000 for the down payment on a home as a first-time home buyer
• Medical expenses not covered or reimbursed by health insurance, or to pay health insurance premiums
• Qualified educational expenses

Question 36

Roth IRA

Answer 36

A nondeductible tax-free retirement plan for anyone with earned income. Maximum annual contribution limits apply as set forth by the IRS plus a catch-up contribution for persons age 50 or older.

Unlike a traditional IRA, contributions are NOT tax deductible. As long as the account has been open for 5 years and the owner is at least 59.5, proceeds under a qualified distribution are received tax free. Taxpayers can also take tax-free and penalty-free distribution of earnings in cases of a death, disability, or qualified first-time home purchase.

A nonqualified 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 maximum IRA contribution for one IRA.

Question 37

Rollovers and Transfers of IRAs

Answer 37

The IRS permits an IRA rollover or a transfer from one account to another. This may avoid taxation as an early withdrawal.

Question 38

IRA Rollover

Answer 38

If the payment is made directly to the IRA owner, they 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 in a 12-month period. A 20% withholding 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. While this is reportable, the income is not taxable, and there is no 60-day requirement.

Question 39

IRA Transfer

Answer 39

In many cases, IRA assets can be transferred 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.

Question 40

Qualified Retirement Plan Types

Answer 40

There are two broad categories of qualified retirement plans:

• Defined Benefit Plan
• Defined Contribution Plan

Question 41

Defined Benefit Plan

Answer 41

Provides employees with a fixed an known benefit at retirement, the amount of which depends upon length of service and highest salary attained. The company assumes the responsibility for making sure money will be available to fund a pension for retiring workers.

Question 42

Defined Contribution Plan

Answer 42

Provides employees with a retirement benefit based on the value of the employee’s account at retirement. The employer, employee, or both can make contributions. This is a type of retirement plan in which a certain amount or percentage of money is set aside each year by a company for the benefit of the employee.

Question 43

Savings Incentive Match Plan for Employees (S.I.M.P.L.E)

Answer 43

• May be established as either an IRA or a 401(k) plan
• Employer;s contribution must be immediately vested at 100%, meaning employee is entitled to all the employers’ contributions immediately
• Only available to companies with FEWER THAN 100 employees and must be the ONLY type of plan the company has available for employees
• The advantage with this plan is the elimination of high administration costs

Question 44

Simplified Employee Pensions (SEPs)

Answer 44

• 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.
• SEP plan uses employer-funded IRAs.
• The employer makes contributions and deducts the payments as a business expense.
• All distributions to employees are taxable upon receipt.

Question 45

Self-Employed Plans (HR 10 or KEOGH Plans)

Answer 45

• Available to unincorporated sole proprietors and their eligible employees - silent partners are NOT eligible.
• Contributions for eligible employees are mandatory and based on the percentage of contribution made by the employer for his or her own account.
• These contributions are deductible
• Before 2001, Keogh Plans wee a popular choice for high-income self-employed people. Today, they’ve been largely replaced by SEP IRAs, which have the same contribution limits, but much less paperwork.

Question 46

Profit-Sharing and 401(k) Plans

Answer 46

A 401(k) Plan is a defined contribution plan for employees of for-profit companies. It is an elective deferral plan or salary reduction. 401(k) Plans also can 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.

Question 47

If employees elect a defined contribution plan:

Answer 47

Employees define their contribution amount as a percentage of income or a fixed dollar amount per payroll period. 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.

Question 48

If the plan is incorporated as a profit sharing plan:

Answer 48

The employer defines the circumstances under which profit-based contributions will be made, and contributions must generally be made in at least 3 out of 5 consecutive years.

Question 49

Tax-Sheltered Annuities (TSAs)

Answer 49

Qualified annuity plans benefiting employees of public schools under the IRC Section 403(b), as well as other nonprofit organizations qualified under Section 501(c)(3). Employees of nonprofit organizations may have an arrangement with the employer whereby the employer agrees with each participating employee to reduce the employee’s pay by a specified amount and invest it 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, are nonforfeitable, and will be paid upon death, retirement, or termination of the employee. Contributions are pretax and the interest earned grows tax deferred.

Question 50

State College Tuition Plans - 529 Plans

Answer 50

Operated by a state or educational institution. These plans offer tax advantages when saving for college and other post-secondary training for a designated beneficiary. Contributions are not tax deductible. However, earnings are not subject to federal tax (and typically not state tax) when used for qualified education expenses of the designated beneficiary (a child or grandchild).