Chapter 9 - Tax Treatment of Life Insurance and Annuities

Question 1

List 4 ways that Life Insurance Receives Favorable Tax Treatment

Answer 1

Death Benefits: Paid to individual beneficiaries are generally not included in gross income.
Cash Surrender Value: Income earned but not withdrawn is not currently taxable; if the insured dies without surrendering the policy, the cash value accumulations are never taxed.
Partial Withdrawals: Received tax-free up to the basis (except for Modified Endowment Contracts - MECs).
Policy Loans: Can be tax-free (except for MECs).

Question 2

List 2 formulas upon Surrender of a life insurance contract.
(Taxation of Life Insurance - Living Benefits and Other Lifetime Transactions)

Answer 2

Investment in Contract (Basis): Premiums paid - dividends received - outstanding loans or withdrawals.
Gain at Surrender: Cash surrender value - investment in the contract (taxed as ordinary income).

Question 3

List 2 things about Annual Cash Value Increases and taxability.
(Taxation of Life Insurance - Living Benefits and Other Lifetime Transactions)

Answer 3

Not subject to current income taxation.
Investment gains in variable life insurance contracts are also tax deferred

Question 4

List 3 things about Life Insurance Premiums and taxability.
(Taxation of Life Insurance - Living Benefits and Other Lifetime Transactions)

Answer 4

Premium payments for individual life insurance are not income tax deductible.
If a corporation pays the premium and is not a beneficiary, the premium is considered compensation to the employee and is deductible by the employer.
Employers may deduct premiums for group term life insurance provided to employees, subject to limits.

Question 5

List 3 things about Dividends and taxability.
(Taxation of Life Insurance - Living Benefits and Other Lifetime Transactions)

Answer 5

Generally, not taxable but considered a return of premium, reducing the policyowner’s investment in the contract (basis).
If dividends exceed premiums, the excess is taxed as ordinary income.
Interest earned on dividends left with the insurance company is taxable as ordinary income.

Question 6

Withdrawals on Life Insurance from the cash value are subject to….

Answer 6

first in, first-out (FIFO) basis treatment.

Question 7

MECs are subject to…

Answer 7

last in, first-out (LIFO) basis recovery and a 10% penalty on taxable amounts withdrawn before age 59½.

Question 8

List 3 types of payments at surrender related to taxability.

Answer 8

Lump-Sum Payment: Gain at surrender equals cash surrender value minus investment in the contract, taxed as ordinary income.
Interest Payments: Interest on proceeds left with the insurer is taxable as ordinary income.
Installment Payments: Portion not a return of principal is taxed as ordinary income.

Question 9

What are the tax free exchanges for life insurance?

Answer 9

No gain or loss recognized on exchanges under Section 1035 for life insurance, endowment policies, annuity contracts, and qualified long-term care insurance policies.

Question 10

Regarding the transfer for value of life insurance, proceeds are includible in the gross income of…

Answer 10

the transferee to the extent they exceed the basis, except in specific situations where the transfer retains tax-free status.

Question 11

Premium payments required by a divorce settlement are considered (2 things)

Answer 11

alimony
and are not deductible, nor is receipt includible in payee’s income for post-2019 divorces.

Question 12

Regarding the taxability of Lump-Sum Death Benefits, they are generally…

Answer 12

excludable from gross income.

Question 13

Regarding the taxability of Interest-Only Payments, interest is taxable as ____.

Answer 13

ordinary income.

Question 14

Regarding the taxability of Installment Payments, the principal portion is ____; interest portion is ____.
Payments received as an annuity have a return of…

Answer 14

tax-free
taxable as ordinary income.
basis component and an interest component

Question 15

List 3 things associated with taxation on federal estate.

Answer 15

Death benefits avoid probate if there is a named beneficiary.
Included in the gross estate in certain situations, such as retention of incidents of ownership or proceeds payable to the estate.
Unlimited marital deduction can be utilized if proceeds are payable to the spouse.

Question 16

Under a viatical settlement, the insured is expected to…

Answer 16

die within 24 months, as certified by a doctor.

Question 17

List 3 aspects of Viatical settlements.

Answer 17

Terminally Ill: Proceeds from the sale of the policy are not subject to income tax.
Chronically Ill: Gain from the sale is excluded if proceeds are used for long-term care.
Third Parties: Do not qualify for tax relief.

Question 18

Withdrawals Before Annuitization…
(Tax treatment of annuities)

Answer 18

For annuities purchased before August 14, 1982, FIFO method applies.
For annuities purchased on or after August 14, 1982, LIFO method applies.

Question 19

Payments Before Life Expectancy…
(Tax treatment of annuities)

Answer 19

Considered partially return of tax-free basis and partially taxable income using an exclusion ratio.
Payments beyond life expectancy are fully taxable.

Question 20

Variable Annuities…
(Tax treatment of annuities)

Answer 20

Exclusion amount is determined by dividing cost basis by the expected term.
Payments beyond life expectancy are fully taxable.

Question 21

Finish this sentence: Ten-Year Forward Averaging is…
(Tax treatment of annuities)

Answer 21

not available for annuities.

Question 22

Finish this sentence: Premature Distributions are subject to a…
(Tax treatment of annuities)

Answer 22

10% penalty before age 59½.

Question 23

Finish this sentence: Entity-Owned Annuities earnings are treated as…
(Tax treatment of annuities)

Answer 23

ordinary income or loss.